Chapter-One

Overview of Public Finance & Taxation

 Governments, all over the world have started
number of public projects. To provide social facilities,
the government requires adequate revenue.
 Public Finance, therefore, deals with the income and
expenditure of public authorities. It deals with the
financial operations or finances of the government.
The government raises revenue from internal as well
as external sources to incur huge expenditure on
various functions the government has to perform.
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Public finance is thus concerned with the use and
accomplishment of essential monetary resources
of the government.
Public finance deals with how and through what
different sources the government gets income,
how it spends it and how it controls and
administers its incomes and expenditures.
Therefore, the subject matter of public finance
deals with public revenue, public expenditure,
and public debt.
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 Definition and Scope of Public Finance
Public finance is a very old science and different
economists have defined it in their own ways.
Is concerned with the income and expenditure of
public authorities and with the adjustment of one
to the other.” Huge Dalton
Is the study of the principles underlying the
spending and rising of funds of public authorities.”
Findley Shirras
Deals with the provision custody and disbursement
of resources needed for conduct of public or
government functions.” Lutz
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Deals with expenditure and income of public
authorities of the state and their mutual
relations as also with the financial
administration and control.” Bastable
All of them say that it is a study of income
and expenditure of the central, state, and
local governments. Government performs
many functions which the individual cannot
or do not perform. Therefore, rising of funds
for the expenditure and their disbursement
constitutes the subject of Public finance.
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Therefore, Public Finance is the study of the role
of the government in the economy. It is the branch
of economics that assesses the government
revenue and government expenditure of the
public authorities and the adjustment of one or
the other to achieve desirable effects and avoid
undesirable ones.
 what is a Finance? Finance is defined as the
management of money and includes activities
such as investing, borrowing, lending, budgeting,
saving, and forecasting.
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There are three main types of finance: (1) personal, (2)
corporate, and (3) public/government.
The easiest way to define finance is by providing
examples of the activities it includes:
 Saving personal money in a high-interest savings
account
Developing a forecast for government spending and
revenue collection.
Borrowing money from institutional investors by issuing
bonds on behalf of a public company
Lending money to people by providing them a
mortgage to buy a house with.
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Importance of public finance
Why is public finance important?
Majorly, the goal of public finance is to
monitor and recognize when, how and why
the government officials should intervene in
the current economy
Understanding certain roles played by the
government and how changes may affect the
economy are a few important aspects of
public finance professionals.
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Thus, it is evident Public finance is very important
for the growth and development of a country.
It is obvious that the government of a country can
push up the industrial and economic development
of the country, provide more employment
opportunities, encourage investments and savings
in the desired direction and increase social
benefits through public expenditure.
It therefore, affects the overall economic and
social system of the country. The major
importance of public finance are listed below as:
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1. Price stability:
The government uses the public finance in order to
overcome form inflation and deflation.
 During inflation it reduces the indirect taxes and
genera expenditures but increases direct taxes and
capital expenditure.
It collects internal public debt and mobilizes for
investment. In case of deflation, the policy is just
reversed.
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2. Economic stability:
The government uses the fiscal tools to stabilize
the economy.
During prosperity, the government imposes more
tax and raises the internal public debt.
The amount is used to repay foreign debt and
invention.
The internal expenditures are reduced. During
recession, the case is just reversed.
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3. Equitable distribution:
The government uses the revenues and
expenditures of itself in order to reduce inequality.
If there is high disparity it imposes more taxes on
income, profit and properties of rich people and
on the goods they consume.
The money collected is used for the benefit of
poor people through subsidies, allowance, and
other types of direct and indirect benefits to them.
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4. Proper allocation of resources:
The government finance is important for proper
utilization of natural, manmade and human
resources.
For it, on the production and sales of less desirable
goods, the government imposes more taxes and
provides subsidies or imposes taxes lightly on more
desirable goods.
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5.Balanced Development :
 The government uses the revenues and expenditures in
order to erase the gap between urban and rural and
agricultural and industrial sectors.
For it, the government allocates the budget for
infrastructural development in rural areas and direct
economic benefits to the rural people.
6.Promotion of export:
The government promotes the export imposing less tax
or exempting form the taxes or providing subsidies to the
export oriented goods.
It may supply the inputs at the subsidized prices. It
imposes more taxes on imports and so on.
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7. Infrastructural development:
The government collects revenues and spends for
the construction of infrastructures.
 It has to keep peace, justice and security too.
 It has to bring socio-economic reformation too.
For all these things it uses the revenues and
expenditures as fiscal tools.
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What is Tax?
A tax is a compulsory financial charge or some
other type of levy imposed on a taxpayer (an
individual or legal entity) by a governmental
organization in order to fund government spending
and various public expenditures. A failure to pay,
along with
Taxation is the means by which a government or
the taxing authority imposes or levies a tax on its
citizens and business entities. From income tax to
goods and services tax (GST), taxation applies to all
levels.
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Scope of Public Finance
• The subject matter of the public finance is
classifies under five broad categories.
• 1. Public Revenue
• 2. Public Expenditure
• 3. Public Debt
• 4. Financial Administration and Control, and
• 5. Economic Stability and Growth.
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(1) Public Revenue
Revenue includes all incomes irrespective of the
source they are obtained from. Thus, in the wider
sense, we can include taxes as well as borrowings
under public revenue.
But in the interest of the clarity, public revenue
includes only those incomes which do not carry
with them the obligation of repayment for the
state. Thus, public revenue implies raising income
by way of taxation.
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(2) Public Expenditure
Public expenditure is the end and aim of the
collection of revenues. Public expenditure is
concerned with Principles and problems relating to
the expenditure of public funds.
The fundamental doctrine that governs the
distribution of the expenditure among various
heads. Various effects of public expenditure on
total employment, total income, aggregate
investment, output, distribution and general price
level etc..
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Public expenditure is also used as a tool for
implementing welfare, growth, stabilization and
other policies, by the government.
(3) Public Debt
A public authority can obtain income through
loans and public borrowings. The study public debt
also includes:
(i) Methods and objectives of public borrowings;
(ii) Management of public debt
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4) Financial Administration and Control:
Public finance also examines the mechanism by which
the above processes are carried on.
 Without a study of relevant dimensions of financial
administration the subject of public finance remains
incomplete.
Thus financial administration and control include the
following:
 Study of budgets and their procedure. Budget as a
instrument of securing certain objectives, such as
promotion of employment, economic growth with
stability, welfare of the weaker sections, infrastructural
development for promoting private investments, etc.
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Financial and physical controls through different
fiscal tools for controlling private expenditure in
the economy to avoid the effects inflation
deflation, recession etc.
(5) Economic Stability and Growth
The study of public finance includes fiscal policy of
the government in dealing with inflationary and
deflationary situations, instability of the price level,
promotion of full employment, growth of
economy, welfare of the people, etc.
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Public Finance and Private Finance
Finance in general means public as well as private finance.
Public finance relates to the money-raising and income-
expenditure functions of the government.
Private finance refers to the income-expenditure phenomenon
of an individual or private business. By private finance mean
the financial problems and policies of an individual economic
unit.
Similarities
(1) Satisfaction of Human Wants;- Both the public and private
finance have the same objective, i.e., the satisfaction of
human wants. Public finance is concerned with the satisfaction
of social or collective wants, whereas private finance is
concerned with the satisfaction of personal or individual wants.
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(2) Maximum Advantage from expenditure;- Both the
public finance and private finance try to secure maximum
advantage or maximum benefit.
An individual or a corporation or a private business firm
tries to obtain maximum advantage from his expenditure.
Similarly, the government also tries to obtain maximum
good of the people by incurring expenditure on the society.
3) Borrowings;- Another similarity between the public
and private finance is that many times both have to
be obtained from the market in the form of
borrowings whenever the expenditure of either the
government or any individual or firm exceeds their
income/revenue.
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(4) Engagement in Similar Activities:
Both the private and public sectors are engaged in
activities that involve lots of purchases, sales and
other transactions. Similarly, they are engaged in
production, exchange, saving capital accumulation,
investment, and so on.
In order to finance these operations, the government,
creates money, raises loans and makes payments etc.
Similarly, a private economic unit lends, borrows,
receives payments, and makes payments and so on.
In these respects, therefore, both the public and
private finance are quite similar to each other.
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(5) Scarcity of Resources;- The scarcity of
resources is also an important factor which is
common to both. They have unlimited objectives,
whereas the resources are limited.
(6) Problem of Adjustment of Income and
Expenditure: Another similarity between public
and private finance is that both the public as well
as private sectors face the problem of adjustment
of income and expenditure.
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Dissimilarities
(1) Motive;- The motive of private finance is personal
interest or benefit, whereas the motive of public finance is
social benefit or public welfare.
(2)Adjustment Approach of Income and Expenditure;-
Another dissimilarity between the individual’s private
finance and the government’s public finance is that every
individual tries as far as possible to adjust his expenditure to
his income because his expenditure depends on his income.
Conversely, the government first prepares its budget.
In other words, the government first determines its
expenditure and then devises ways and means to raise the
requisite revenue to meet its expenses.
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(3) Nature of Resources:- The resources (private finance)
of an individual are more or less limited, whereas the
resources of the government (public finance) are
enormous. Government can raise resources from tax
sources as well as non-tax sources. The government can
borrow from internal as well as external sources.
(4) Coercive Methods:- An individual (private finance)
cannot use coercive methods to raise his income,
Whereas the government (public finance) can use forceful
methods to collect revenue. In other words, to collect
revenue, the government imposes taxes at a high rate on
the people irrespective of their capacity to pay. Private
individuals or bodies have no such powers.
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(5) Elasticity of Finance:- Public finance is elastic in
nature-as compared to private finance.
 Public finance can be increased by imposing
various taxes as public finance is open to drastic
changes. Private finance on the other hand, cannot
be increased as there is not much scope for
changes in private finance.
(6) Right to Print Currency: - The government has a
right to print currency which is legal, whereas
private individual does not enjoy such a right.
 Chapter-Two
PUBLIC REVENUE
Government has played an important role in the
socio economic development of society.
Social development may be in the form of raising
the level of living and social welfare in the form of
providing social amenities to the people.
 Social amenities are in the form of education,
health and sanitation, utilities like electric supply,
water supply etc.. and recreation facilities.
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The process of socio-economic development
requiring huge expenditure and cannot be carried
unless the government has the perennial source of
income. Every government has two important
sources of revenue.
These are:
(a) Tax sources, and
(b) Non-tax sources.
What is a Tax?
Tax is one of the most important sources of revenue to
every government. In the earlier days, payment of
taxes was optional.
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A choice was given to the people to pay the tax and
to the benefit of social amenities in the form of
education, health and sanitation, utilities and
recreation facilities.
Naturally, everyone interested in availing social
amenities used to evaluate the benefit derived by
him in exchange for the tax to be paid by him.
But the option in the payment of tax created lot of
problems for the government in fulfilling their
obligations to society.
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Hence, in modern times, option was withdrawn and

tax became a compulsory contribution by every
citizen to the government to enable the government
to fulfill its commitments towards society.
Every Government imposes two kinds of taxes:
(1) Direct taxes, and
(2) Indirect taxes
A tax, in the modern times, therefore is a
compulsory levy and those who are taxed have to
pay the sums irrespective of corresponding return of
services or goods by the government.
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It is not a price paid by the tax-payer for any
definite service rendered or a commodity supplied
by the government
The benefits of public expenditure may go to
anyone irrespective of the taxes paid.
Therefore, we may say that taxes are compulsory
payments to government without expectation of
direct return or benefit to the tax-payer.
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Sources of Public Revenue
The important and common sources of public
revenues are:
 Taxes( Direct and Indirect taxes).
 Income from currency
 Sale of public assets
 Commercial revenues
 Administrative revenues
 e.g., Fees, fines charges , licenses fees .
 Grants and gifts
 Borrowing and Loan etc…
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Basic Categories of Government Receipt:

1.Revenue Receipts
2.Capital Receipts
A. Revenue Receipts
 It includes “routine” and “earned” ones
 1. Tax-revenue
 2. Non-tax revenue.
Tax revenue itself is divided into three sections:
i. Taxes on income:
 It covers corporation/Business tax, income tax
and similar other taxes, if any, in force.
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ii. Taxes on property and capital transactions:
 Taxes on specific forms of wealth and its transfers such as ,
wealth tax, gift tax, Land use tax, land revenue and stamps
and registration fees, etc.
iii. Taxes on commodities and services:
 This section includes taxes on production, sale, purchase,
transport, storage, and consumption of goods and services.
2. Non-tax Revenue Receipt:
Interest receipts, dividends and profits:
interest receipts on loans by the government to other
parties, Dividends and profits from public sector
undertaking. E.g contributions from posts and
telecommunications, Electricity Etc…
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• Other non–tax revenue:

It covers revenue from various government
activities and services such as from administrative
services, public service commission, police, jails ,
agricultural and allied services, industry and
minerals, water and power development services,
transport and communications, supplies and
disposal, public works, education, housing,
information and publicity, broadcasting, grants-in-
aid and contributions etc.
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B. Capital Receipts:
Capital receipts of the government take money forms.
The most important one comprises of borrowings which
can be classified in terms of their origin and maturity on
the basis of origin, public borrowings may be external
(outside the country), or internal (with in the country).
In terms of maturity, there may be, ”long term”,
“medium term”, or “short term” loans with specific
demarcation of boundaries for each.
They may be marketable or non- marketable, interest-
free or interest bearing, etc. Some capital receipts may
be in the form of grants and donation.
Con’t
Sources of public revenue in Ethiopia
Tax revenue
Non-tax revenue
i. Tax Revenue
Direct Taxes: Example
 Personal income tax
 Business income tax
 Capital gain tax
 Rental income tax
 Interest income tax
 Tax on dividend and lottery
 Rural and urban land use fee
II. Indirect taxes: Example
 Customs duties
 Turnover tax
 Excise tax
 VAT
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ii. Non-tax revenue
Administrative revenues(fees Charges,Penality
etc..)
Government investment income
Dividend
Privatization proceeds
Capital income from sale of goods and services.
 Chapter-three
Public Expenditure
PUBLIC EXPENDITURE:
 PE is incurred by public authorities - either for the
satisfaction of collective needs of the citizens or
for promoting their economic and social welfare.
It is incurred by the government for the
attainment of public good.
Every government has to maintain law and order,
armed forces for providing protection, schools,
health of the people, arranging for cheap food,
cloth and low-cost housing for the poor and so on.
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All these mixed activities which are increasing

every year require huge funds.
Therefore public expenditure, deals with the
expenditure which a government incur for its own
maintenance, the society and the economy and
helping other countries.
Current and Capital Expenditure:
Technically, in the structure of a budget, most
governments classify public expenditure into two:
(i) Current expenditure, and
(ii) Capital expenditure.
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Current expenditures:
They are also referred to as non-developmental
expenditure.
All sorts of administrative and defense expenditure they
are intended for continuing the existing flow of goods and
services and maintaining the capital of the country whole.
Capital expenditures:
Capital expenditures contribute to increased productive
capacity of the nation.
They are also known as development expenditure.
Example: Expenditures on construction of dams, public
works, state enterprises, agricultural and industrial
development.
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Objectives of Public Expenditure:
Dr. Dalton divided the aims of public expenditure
into two parts:
 (i) Security of life against the external aggression
and internal disorder and injustice.
(ii) Development or up gradation of social life in
the community.
 The public authority works in many ways for the
benefit of the people. The government organizes
the generalized services like public health and
education. The whole society is benefited by these
functions of the state.
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 Secondly, in modern times, the responsibilities of
the government are increasing every year.
 Though, through public expenditure the
government influences directly or indirectly, the
industrial and commercial system of the nation
thereby helps towards the economic and social
development of the society.
 Public spending should be designed to optimize
the level of investment in such a way as to
maintain full employment--with growth. Public
spending may be incurred at an increasing rate in
the backward region to uplift their economy.
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Reasons for Growing Expenditure:
Population growth:
The growth in the numbers particularly in
developing countries has been a major cause of
the continuous rise in public expenditure.
 Along with growth in the numbers, the
responsibility of government relating to public
services has been multiplied.
To check the growth of population, again, the
government has to incur a huge expenditure.
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Increasing urbanization:
As the rural areas cannot subsist the growing
population, there is a continuous rush to the urban
areas.
The size of cities is becoming larger and larger,
while newer urban habitations are springing up.
The maintenance of complexity of life has,
therefore, become costlier and the government has
to squarely face the problem.
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Maintenance of law and order:

Along with the growth of population, urbanization
and complexities of modern economic and
sociopolitical life, law and order problems have also
multiplied.
The government responsibilities of internal
protection of people from breach of peace by
antisocial elements have gradually become multi-
sided requiring government expenditure of more
and more funds
Con’t
Welfare activities.
Previously, public expenditure was limited by only a few
functions of government, viz, the defense, maintenance of law
and order and administration.
But, presently, the countries have emerged as modern welfare
states where the greatest good of the greatest number is the
main objective of statehood.
 The government now has to assume such responsibilities
as family and child welfare, social security like old age
pension, unemployment benefit, sickness benefit, etc.
housing for the poor, welfare of handicapped and
backward classes, rehabilitation of displaced persons,
subsidy on food and production inputs, etc…
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Public expenditure on welfare program has,

therefore, become tremendous with the passage of
time.
Provision of public goods and utility services:
 Public goods are those that are consumed equally
by all. They cannot be sold in the private market.
Defense and police services, justice, roads,
irrigation and flood control projects, public parks,
etc. are all examples of public goods.
They involve huge investment and have to be
provided by the government.
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Moreover, there has been a growing trend of public utility
services like railways and other transport services, postal,
telegraph and telephone services, electricity services, etc.
Coming under the government sector. They all involve heavy
expenditure on installation and maintenance.
Servicing of public debt:
 A substantial part of the huge expenditure program of
government is met from public borrowings.
This is because resources cannot be mobilized from
taxation beyond a limit. Hence, modern states incur
considerable internal and external public debt. The
repayment of debt and obligation to pay service
charges become huge.
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International obligation:
Finally, the modern states have to maintain many
international socio-political and economic links.
They have to maintain diplomatic relations,
economic links with international institutions like
I.B.R.D. ( the International Bank for
Reconstruction and Development), I.M.F.
( International Monetary Fund) etc,
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Socio-cultural and academic exchange relations, linkage with
development programs of the type of economic co-operation,
gifts and donations, regional economic integration and
membership of other international organization like UNO (United
Nations Organization), etc – all these involve a considerable
amount of public expenditure.
Defense: -
Due to the invention of nuclear weapons there is always a
danger of foreign aggression. International political situation
is uncertain and insecure. As such, every nation has to
prepare itself for a strong defense.
The defense expenditure in the form of expenditure on war
materials, maintenance and growth of armed forces, pension
to retired war personnel etc. are, are perpetually rising.
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Transport and Communication: With the expansion of
trade and commerce, the state has to provide and
maintain a quick and efficient transport system.
Transport being a public utility, the state has to provide
it cheaply also.
The government has to spend a lot on constructing new
railway lines, good roads, new roads, highways, bridges
and even canals to connect different areas with a
smooth transport system as a precondition of growth.
Rising Trend of Prices:
 Public expenditure is also increasing in every country
due to rising trend of prices.
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The reason is that the government has to buy

goods and services from the market at higher
prices.
The government has also to increase the salaries,
dearness allowance etc., of government employees
leading to a rapid increase in government
expenditure.
The Rural Development Effect:
 In an underdeveloped country, the government
has also to spend more and more for rural
development.
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It has to undertake schemes like community
development projects and social measures. The
government also incurs expenditure on imparting
training to personnel for implementing rural
development programmers.
Canons of Public Expenditure:
It used for the fundamental rules or principles governing
the spending policy of the government. According to
Prof. Findley Shirras, the canons are:
1.Canon of Benefit:
 Public expenditure should be so planned and
implemented as to bring about the greatest possible
benefit to society.
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This canon is simply a reminder to the public
authorities that whatever they spend they should
do it according to the principle of maximum social
advantage.
 What it means is that all such expenditures which
do not bring benefit to society should be avoided.
Benefit from public expenditure may be identified
with achievement of proper allocation of economic
resources, proper distribution of income and
wealth in society and stability of price level and
growth of economy.
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2.Canon of economy:
Public expenditure should be incurred carefully so
that there is no wastage of funds. Since resources
are limited in the society, they have to be most
properly utilized.
Economical use means most proper utilization.
Hence the canon remains a constant reminder that
resources must not be misused or wasted.
 Most important reasons of wasteful expenditure
are faulty planning, faulty execution, corrupt
practice and delay due to time lag between plan
and execution and, hence, escalation of prices.
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3.Canon of sanction:
This cannon suggests that no public spending
should be made without the approval of proper
authority.
Only obtaining prior sanction is not sufficient. It
must be properly inspected and examined whether
the sanctioned amount of money is being spent
properly on sanctioned items or not.
 As a rule, therefore, money must be spent on the
purpose for which it is sanctioned by the highest
authority and accounts properly audited.
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4.Canon of surplus:
This canon requires that expenditure of public
authorities should be kept within the limits of
current revenues.
 If possible, the expenditure should be less than
the earnings of government so that the surplus so
generated can be used when there is unavoidable
deficit.
Surplus can be generated either by controlling
expenditure or by increasing current revenues.
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5.Canon of elasticity:
Canon of elasticity requires that the rules of public
expenditure should not be too rigid to achieve the real
purpose and that it should be allowed to vary according
to the needs and circumstances.
For example, if the economy suffers from
unemployment and deficiency of demand, there should
not be a rigidity that the budget should be balanced.
Under such situation, the government should go for a
deficit budget and inject additional purchasing power
into the economy so that effective demand is increased
and factors of production are employed on larger scale.
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 in case of emergent situations like flood relief,
sanctioning authority should be vested with the
lower rank spending unit since there is no time to
secure sanction from higher authorities.
Flexibility of expenditure should be provided under
such circumstances.
6.Canon of Productivity:
 This canon or principle implies that the expenditure
policy of the Governments should be such that
would encourage production in a country.
That means a large part of public expenditure must
be allocated for development purpose.
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7.Canon of Equity:
 One of the foremost aims of public expenditure is
also to ensure the just and equitable distribution of
is more significant for the countries where the gap
between the highest income and the lowest
income groups is very wide.
8 Canon of certainty:
This canon requires that public authorities should
clearly know the purpose and extent of public
expenditure. The spending unit should be certain as
to the amount and objective of public expenditure.
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Effects of Public Expenditure:
In modern government Public Expenditure regarded
as a means of securing social ends. Public
Expenditure produces many direct and indirect
socio-economic effects.
(1) Effects upon ability to work, save and invest:
Ability to work, save and invest depends upon the
health and efficiency possessed by the persons.
Health and efficiency depends upon the level of
consumption and level of consumption depends
upon the public expenditure incurred by the
government.
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Public expenditure on education, medical services,

cheap housing facilities, means of transport and
communication etc… will increase the efficiency of
persons to work.
Some of the expenditure, like the expenditure on
free education, unemployment benefit and free
medical facilities etc., are helpful in increasing the
purchasing power of the people especially of the
low income groups and hence it helps to protect
and promote the efficiency of the people and their
ability to work and save.
Con’t

Public expenditure on increasing the salaries and

wages of the people and the supply of goods and
articles at cheap rates to them will increase their
purchasing power, standard of living, health,
efficiency and hence their ability to work and save
may increase.
Likewise, public expenditure on the maintenance
of law and order, creates confidence in the minds
of the people and hence it encourages them to
make investment in productive activities.
Con’t
As production increases, income of the people also
increases; hence their ability to work, save and invest also
goes up.
Thus it is evident that public expenditure can promote ability
to work, save and invest and thus promote production and
employment.
(2) Effects upon willingness to work, save and invest:
Public expenditure also affects the willingness of the people
to work, save and invest. Pension, provident fund, interest
loan, free medical and unemployment allowances and other
government payments provide security to a person and,
therefore, reduce the willingness of persons to work and
save, when a person knows that will be looked after by the
government when he is not in a position to earn any income.
Con’t
In the absence of any saving, the question of
investment does not arise at all. On the contrary,
expectation of larger amenities and higher standard
of living would stimulate people to work hard.
 It is this encouragement which would encourage
them to save more and to invest their savings for
production purposes.
 Expenditure on benefits such as sickness benefits
would certainly increase the desire of the people to
work more, since they are assured of relief if they
fall sick due to hard work.
Con’t
(3) Effects on diversion of resources:
Public expenditure also affects the diversion of
resources. Government incurs public expenditure
in the form of giving financial assistance to
productive sector.
In the same way, if the government wishes to
attract productive resources to a particular area or
region, it will start giving variety of incentives in
the form of tax holidays and other allowances or
concessions etc. to the industrialists.
Con’t

4. Effects of public expenditure on distribution:

Public expenditure also helps the government in
bringing about equitable distribution on income and
wealth.
Not only taxation policy but public expenditure policy
can also remove inequalities in the distribution of
income and wealth.
To bring about equitable distribution of income and
wealth, the government should impose higher taxes
on the richer section of society and the amount
realized from them should then be spent on the
poorer section of society by way of providing social
amenities, and subsidies to them.
Con’t
Public expenditure has, thus, an important role in
reducing economic inequalities in the society.
5.Effects of public expenditure on employment:
Public expenditure affects employment as well as
employment opportunities. It can increase
employment in the country.
Therefore, the public expenditure policy of the
government should be so devised as to create
additional jobs both in the public and private
sectors. The following expenditures of the
government increase employment opportunities.
Con’t

(a) Heavy expenditure in the public sector

For the economic development of the country, the
government should make investment in public
sector such as heavy engineering, dam and canal
coal etc..
Production goods sector provides direct
employment to the people by creating millions of
jobs.
Thus it clearly becomes the responsibility of the
state to prevent a situation of unemployment.
Con’t

(b) Expenditure on public utilities:

Public expenditure incurred by the government on public
utilities, such as supply of water, electricity, telephone
services, etc., create a large volume of employment.
(C)Public expenditure to encourage small-scale industries
To promote employment in small-scale industries, the
government should provide tax incentives and allowances to
such industries.
The government should incur public expenditure on small-
scale sector in the form of cheap credit, supply of raw
materials at concessional rates, free technological assistance,
helping these industries in the marketing of goods etc.
In this way, large employment is created in the small-scale
sector.
Con’t
(d) Public expenditure to create employment in
backward areas:
To create employment opportunities in back ward
regions, the government should promote industries in
the public sector and private sector in backward areas.
To encourage industries in the public as well as private
sectors, the government should grant deductions and
concessions to such industries.
 If public expenditure is directed towards the promotion
of industries in the public and private sectors in
backward areas, not only will additional jobs be
created, but the markets will be also widened and there
will be all round economic development of the country.
Con’t

(e.) Effects of public expenditure on economic

stability:
Economic stability is judged by the behavior of
prices. Price stability is related to the manner in
which price behaves in an economy.
There should be a normal rise in price because
normal is considered as a sign of a healthy
economy problem arises whenever there are price
fluctuations.
Price fluctuations may be known as abnormal
economic situations.
Con’t

There may be 2 state of abnormal price behavior:

 (i) Inflation,
 (ii) Deflation or depression, and
Effects of public expenditure in Inflation:
Inflation is a state of rising money supply, rising
demand but stable supply.
Public expenditure may be useful in controlling
inflation.
In this situation the aim of the government should be
to spend than its revenue. Inflation may be averted by
reducing public expenditure on civil services, defense,
interest payments etc..
Con’t

Effects of public expenditure in deflation/depression:

Depression is a state of falling price, falling money
supply and falling demand. Falling prices cause
losses among business-men and manufactures and
this leads them to curtail production and
employment.
Thus, a large number of workers are thrown out of
employment. In such a situation, the government
should employ workers on public works projects.
Con’t

The employed workers receive wages from the

government and can thus increase the demand for
various commodities.
The increased demand leads to increase in
production.
Thus, the objective of public expenditure during
depression should be to create effective demand
for consumer goods, which would create
employment and thus, would help to maintain
economic stability.
 Chapter-Four
Public Debt
NATURE AND KINDS OF PUBLIC DEBT:
Public debt is of recent growth and was unheard of
prior to the 18th century. In modern times, however,
borrowing by the States has become a normal
method of government finance along with other
sources such as taxes, fees, etc.
 The government may borrow from banks, other
International Financial organizations . Besides, it can
borrow within the country or from outside.
Public debt is also sometimes referred to as
government debt.
Con’t

Public debt is a debt or loan taken by the govt.

from own people Foreign countries or both.
Classification of public debt:
Source of Borrowing
Purpose of the loan
According to nature
Funded and unfunded debt
Time Duration of loan
1.Source of Borrowing (internal debt and external
debt).
Con’t
There are two sources of public debt, internal and
external.
Internal debt refers to public loans floated within
the country, while external debt refers to the
obligations of a country to foreign governments, or
foreign nationals or international institutions.
Though external debt is becoming very common
these days, there has been general prejudice
against foreign debt, based on ignorance and faulty
economics.
Cont

The government loan is generally in the form of bonds

(or treasury bills if the loan is required for short
periods) which are promises of the government to pay
to the holders of these bills the principal sum along
with interest at the stated rate. Borrowing is resorted to
in order to provide funds for financing a current deficit.
Public debt is also sometimes referred to as
government debt. It is a term for all of the money
owed at any given time by any branch of the
government. i.e. federal government, the state
government, and even the municipal and local
government. Public debt is a debt or loan taken by the
govt. from own people Foreign countries or both.
Con’t
Classification of public debt
Source of Borrowing
Purpose of the loan
According to nature
Funded and unfunded debt
Time Duration of loan:
1. Source of Borrowing (internal debt and external debt).
There are two sources of public debt, internal and
external.
Internal debt refers to public loans floated within the
country, while external debt refers to the obligations of
a country to foreign governments, or foreign nationals
or international institutions.
Con’t

2. Purpose of the loan (Productive and unproductive

debt)
Public debt is said to be productive if the
investment yields an income which will not only
meet the yearly interest payments of the debt but
also help repay the principal over the long run.
 All public debt can be said to be productive in
another sense too.
Con’t
The government may undertake certain projects
through loans which may not be productive in the
sense given above but which may be really useful
to the community – for example, a railway line
connecting a backward region, an irrigation work to
prevent famine conditions in an area, and so on.
In this sense all public debt is productive.
But in many cases, public debt may be contracted
during war-time to finance war. Such debt is
unproductive because it does not create an asset; it
is a dead-weight debt or a useless burden on the
community.
Con’t
3. According to nature: Compulsory and voluntary debt
When the govt. borrows from public by using
forceful method,. For example, the loans raised
during an emergency e.g. war.
When the govt. borrows money from the public,
individuals and institutions by issuing securities like
bonds etc., it is called voluntary debt.
4. Funded debt and unfunded or floating debt.
Broadly speaking, funded debt is a long-term debt,
undertaken for creating a permanent asset and the
government normally makes arrangements about
the mode and the time of repayment.
Con’t
Unfunded and floating debt is a relatively short-
period debt meant to meet current needs.
The government undertakes to pay off the
unfunded debt in a very short period, say, within six
months. Treasury bills are examples of unfunded
debt. The rate of interest on unfunded debt is
lower.
5.Time Duration of loan (short, medium, and long
term loan).
According to time duration of the loan, public debt
can be classified into short term, medium term, and
long term loans.
Con’t

Short term loan is usually incurred for a period

varying from three months to one year. Usually
government gets such loans from the central
(national) banks by using treasury bills.
These loans are also called ‘ways and means
advances’. Such loans are obtained to overcome
temporary deficits in payment to be made by the
government in the course of one year to pay
salaries etc.
Medium term loans are those which are obtained
for more than one year but less than ten years.
Con’t
Usually the governments borrow only long term loans for
more than ten years. The maturity period is long so that the
rate of interest tends to be higher on the long term loan than
short term loan. Long term loans are incurred to finance
development schemes.
Effects of Public Debt.
Public borrowing from individuals and firms has effects on all
aspects of economic life,
Effects on Consumption
 Effects on Production and Investment.
Effects on Distribution
Effects on National Income
Effects on Liquidity
Effects on Money Market
Con’t

Effects on consumption: -
The effect of public debt on consumption depends
upon how it is financed by individuals. If they lend to
the government out of their idle savings,
consumption is not affected.
 If they buy out of past savings it has only a limited
impact on present expenditure. But if they lend by
cutting present savings, it may make them feel less
secure and so they may reduce consumption.
But if the people feel that they have invested in
government securities which are considered safe
investment, they may actually increase their
consumption.
Con’t
Effects on Production and Investment: -
The effect of public debt on production depends
upon whether it affects private investment or not.
 If people buy government bonds by selling their
shares or debentures in private individual firms,
there is an adverse effect on private investment.
But if the money borrowed by the government is
for productive purpose, overall production is not
affected.
But if it is used for wasteful or non-productive
purpose, total investment is affected negatively.
Con’t

 If people buy government bonds by taking away

their bank deposits, bank’s lending capacity is
reduced and this again affects private investment.
 If the government uses the funds for productive
purpose, it can repay it out of income generated by
these projects.
But if public debt is used for unproductive
purposes, it can be repaid only by through
additional taxation in future which affects future
consumption as well as production by reducing
future disposable incomes.
Con’t
However, if public debt is used for welfare schemes, it
may increase people’s efficiency to work and thus
improve productive capacity.
Effects on Distribution.
 Public debt is bound to have effects on distribution of
income because it involves transfer of purchasing
power from one sector to another.
redistribution of income effects of public debt
depends upon whether the taxpayers and the bond
holders are the same people or not.
However if the public debt is used for public welfare
programs especially the poor, inequalities of income
deceases.
Con’t
But if public borrowing creates inflation, the
beneficial effects of redistribution will be
neutralized as prices rise.
Effects on Liquidity.
Effect of public debt on liquidity is favorable because
the governments bonds are liquid assets which can
be sold in the market whenever the bondholders
need money.
. So public debt increases the volume of liquid
assets in the country.
Con’t

Secondly the larger quantity of such liquid

government bonds can result the failure of monetary
policy.
For example, when national bank tries to control
inflation through monetary policy tools like bank rate,
the commercial banks can increase their cash
reserves by selling government bonds.
Burden of Public Debt
Public borrowings are to be paid along with interests.
Govt. imposes new taxes upon the people to repay the
loans and meet the annual interests on such loans. The
sacrifice of the people in the form of tax payment is the
burden of public debt.
Con’t
If the debt is taken for productive purposes, for
e.g., for irrigation, transportation, roads,
information technology, human skill development,
etc., it will not mean any burden.
But if the debt is unproductive it will impose both
money burden and real burden on the economy
The burden of public debt into:
Burden of internal debt
Burden of external debt
Con’t
Internal debt involves a series of transfers of
wealth within the country, i.e., from lender to
government and then later on at the time of
redemption from government to lender.
Money is thus transferred from one section of the
community to other sections.
In order to repay the interest and the principal
amount of the debt, the government has to levy
taxes.
What the taxpayers pay the lenders receive. The
lenders are generally rich people and tax burden is
fall on poor especially in the case of indirect taxes.
Con’t
The net result may be that the wealth is
transferred from poor to rich. This is the loss of
economic welfare.
Burden of external debt:
External debt also involves a series of transfer of
wealth from the foreign lender to the borrowing
country, and when it is repaid the transfer is in the
opposite direction.
As the borrowing country paid interest to the
foreign lenders, a direct money burden is fall on
the whole community.
Con’t

This burden depends on the rate of interest. If the

rate of interest is high, the money burden, is also
high and vice-versa.
The real burden of the external debts depends on
the nature and use of these debts.
If it is used for productive purpose, the real
burden of these debts will be less.
If external debts to be used for non-productive
purposes, much real burden will have to be borne
in order to repay such a debt.
Con’t
As a result the production, consumption and
distribution of income is badly affected.
 Moreover, the foreign lender has direct
involvement in the economic activities of the
country.
Redemption of Public debt:
Redemption is a way of outflow from the burden of
a public debt.
Redemption means repayment of loans. The
various methods available to the government to
pay off its debt are:
Con’t

Repudiation of Debt.
Repudiation of debt means simply that the
government refuses to pay the interest as well as
the principal.
Repudiation is not paying off a loan but destroying
it.
Normally, a government does not repudiate its
debt, for this will shake the confidence of the
general public in the government.
Con’t
However, in extreme circumstances, a government
may be forced to repudiate its internal or external
debt obligations.
 For instance, internally the country may be facing
financial collapse and bankruptcy and externally, it
may be faced with shortage of foreign exchange.
Conversion of Loans:
Another method of redemption of public debt is
known as conversion of loans, that is, an old loan is
converted in to a new loan (in a broad way, conversion
is the same as refunding debt; i.e., repayment of a
debt through a new loan).
Con’t
Conversion may be resorted to:
(i) When at the time of redemption of a loan, the
government has not the necessary funds, and/or
(ii) When the current rate of interest is lower than
the rate which the government is paying for its
existing debt, so that the government can reduce
its interest obligations.
 Conversion of a loan is, always done through the
floating of a new loan. Hence, the volume of
public debt is not reduced. Really speaking,
therefore, conversion of debt is not redemption of
debt.
Con’t

Sinking Fund.
Sinking fund is probably the most systematic and,
therefore, the best method of redeeming public debt.
It refers to the creation and the gradual accumulation
of a fund which will be sufficient to pay off public debt.
Suppose the government floats a loan of Birr10
billions, redeemable in say, 10 years, for the purpose
of road construction.
Year after year, the tax proceeds as well as interest on
investments will make the fund grow till after 10 years
it becomes equivalent to the original amount
borrowed; at that time, that debt will be paid off.
Con’t
One danger of the sinking fund methods is that a
government, in need of money, may not have the
patience to wait till the end of the period of
maturity but may utilize the fund for purposes
other than the one for which originally the sinking
fund was instituted.
 Chapter-Four
Taxation and its characteristics.

Objectives of Taxation
Initially, governments impose taxes for three basic
purposes: to cover the cost of administration,
maintaining law and order in the country and for
defense related issues.
But now government’s expenditure pattern changed
and gives service to the public more than these three
basic purpose and it restore social justice in the society
by providing social services such as public health,
employment, pension, housing, sanitation and other
public services.
Con’t
Therefore, governments need much amount of
revenue than before.
To generate more revenue a government imposes
taxes on various types. In general objective of
taxations are:
1. Raising revenue:
To render various economic and social activities, a
government needs large amount of revenue and to
meet this government imposes various types of
taxes.
Con’t
2. Removal of inequalities in income and wealth:
Government adopts progressive tax system and
stressed on canon of equality to remove
inequalities in income and wealth of the people.
3. Ensuring economic stability:
Taxation affects the general level of consumption
and production.
Hence, it can be used as effective tool for
achieving economic stability. Governments use
taxation to control inflation and deflation.
Con’t
4. Reduction in regional imbalances:
If there is regional imbalance with in the country,
governments can use taxation to remove such
imbalance by tax exemptions and tax concessions to
investors who made investment in under developed
regions.
5. Capital accumulation
Tax concession or tax rebates given for savings or
investment in provident funds, life insurance,
investment in shares and debentures lead to large
amount of capital accumulation, which is essential for
the promotion of industrial development.
Con’t
6.Creation of employment opportunities:
Governments might minimize unemployment in
the country by giving tax concession or exemptions
to small entrepreneurs and labor intensive
industries.
7.Preventing harmful consumptions:
Government can reduce harmful things on the
society by levying heavy excise tax on cigarettes,
alcohols and other products, which worsen
people’s health.
Con’t
8.Beneficial diversion of resources:
Governments impose heavy tax on non- essential
and luxury goods to discourage producers of such
goods and give tax rate reduction or exemption on
most essential goods.
This diverts produce’s attention and enables the
country utilize to utilize the limited resources for
production of essential goods only.
Con’t
9. Encouragement of exports:
Governments enhance foreign exchange
requirement through export-oriented strategy.

These provide a certain tax exemption for those

exporters and encourage them with arranging a
free trade zones and by making a bilateral and
multilateral agreement.
Con’t
10. Enhancement of standard of living:
The government also increases the living standard
of people by giving tax concessions to certain
essential goods.
Characteristics of a Good Tax System
(1) Tax is a Compulsory Contribution
A tax is a compulsory payment from the person to
the Government without expectation of any direct
return.
Con’t
 Every person has to pay direct as well as indirect
taxes.
As it is a compulsory contribution, no one can
refuse to pay a tax on the ground that he or she
does not get any benefit from certain public
services the government provides.
(2) The Assesses will be required to pay Tax if is due
from him
No one can be forced by any authority to pay tax,
if it is not due from him. Suppose, if there is a tax
on liquor, the state can force an individual to pay
the tax
Con’t
 Only when he drinks liquor. But, if he does not
drink liquor, he cannot be forced to pay the tax on
liquor.
 Similarly, if an individual’s income is below the
exemption limit, he cannot be forced to pay tax on
income. For example individuals earning monthly
salary below birr 600 cannot be forced to pay tax on
income.
(3) Taxes are levied by the Government
No one has the right to impose taxes. Only the
government has the right to impose taxes and to
collect tax proceeds from the people.
Con’t
(4) Common Benefits to All
The tax, so collected by the Government, is
spent for the common benefit of all the
people.
In other words, when the government collects
a tax, its proceeds are spent to extend
common benefits to all the people.
 The Government incurs expenditure on the
defense of the country, on maintenance of law
and order, provision of social services such as
education, health etc.
Con’t
Such benefits are given to all the people-
whether they are tax-payers or non-
taxpayers. These benefits satisfy social wants:
(5) No Direct Benefit
In the modern times, there is no direct
relationship between the payment of tax and
direct benefits.
In other words, there is absence of any
benefit for taxes paid to the Governmental
authorities.
Con’t
The government compulsorily collects all types of taxes
and does not give any direct benefit to tax-payers for taxes
paid
(6) Certain Taxes Levied for Specific Objectives
Though taxes are imposed for collecting revenue for the
government to meet expenditure on social wants and
merit wants, certain taxes are imposed to achieve specific
objectives.
. For example, heavy taxes are imposed on luxury goods to
reduce their consumption so that resources are directed
to the production of essential goods, such as cheaper
variety of cloth, less costly goods of mass consumption,
etc
Con;t
Thus, taxes are levied not only to earn revenue but
also for diversion of resources or saving foreign
exchange. Certain taxes are imposed to reduce
inequalities of income and wealth.
(7) Attitude of the Tax-Payers
The attitude of the tax-payers is an important
variable determining the contents of a good tax
system.
It may be assumed that each tax-payer would like
to be exempted from taxpaying, while he would
not mind if other bears that burden
Con’t
In other words, it is essential that a good tax
system should appear equitable to the tax-payers.
(8) Good tax system should be in harmony with
national objectives
A good tax system should run in harmony with
important national objectives and if possible
should assist the society in achieving them.
 It should try to accommodate the attitude and
problems of tax payers and should also take into
consideration the goals of social and economic
justice.
Con’t
It should also yield adequate revenue for the
treasury and should be flexible enough to move
with the changing requirements of the State and
the economy.
(9) Tax-system recognizes basic rights of tax-payers
A good tax system recognizes the basic rights of
the tax-payers. The tax-payer is expected to pay his
taxes but not undergo harassment.
 In other words, the tax law should be simple in
language and the tax liability should be determined
with certainty.
Con’t
The mode and timings of payment should be
convenient to the tax-payer.
At the same time, a tax system should be equitable
between tax-payers. It should be progressive and
burden of taxation should be equitable on all the
tax-payers.
Con’t

Principles of taxation
 A tax system (that is, the set of all taxes) for
achieving certain objectives chooses and adheres
to certain principles which are termed its
characteristics.
 A good tax system therefore, is one of which
designed on the basis of an appropriate set of
principles, such as equality and certainty.
 Therefore, usually economists select some
important objectives and work out the
corresponding principles which the tax system
should adhere to.
Con’t
 The first set of such principles was enunciated by
Adam smith (which he called Cannons ofTaxation):
Canons of Taxation
 The four canons of taxation as prescribed by Adam
Smith are the following:
(1) Canon of Equity:
They advocate progressive taxation to
observe the canon of equity. In other words,
they advocate progression should be the
basis for imposing taxes.
Con’t
(2) Canon of Certainty
This canon is meant to protect the tax payers from
unnecessary harassment by the ‘tax officials’. It
implies that the tax-payer should be well informed
about the time, amount and the method of tax
payment.

The time of payment, the manner of payment, the

quantity to be paid, ought all to be clear and plain
to the contributor and to every other person.
Con’t
3) Canon of Convenience
The third canon of Adam Smith is that of
convenience. According to Adam Smith, “every tax
ought to be so levied at the time or in the manner in
which it is most likely to be convenient for the
contributor to pay it.
In other words, taxes should be imposed in such a
manner and at the time which is most convenient for
the tax-payer, i.e., the best time for the collection of
land revenue is the time of harvest.
 Similarly, taxes on rent of houses should be collected
when it is most convenient for the contributor to pay.
Con’t
(4) Canon of Economy
The fourth canon is the canon of economy. This
canon implies that the administrative cost of tax
collection should be minimum, i.e., the difference
between the money, which comes out of the
pockets of people and that which is deposited in the
public treasury, should be as small as possible.
Administrative cost of tax collection should be
minimum.
 In addition to the above four canons given by Adam
smith, the following other canons have been
advanced by Basable and other economists.
Con’t
(5) Canon of Productivity:
The canon of productivity advocated by Bastable
implies that taxes should be productive. The
productivity of a tax may be observed in two ways:
In the first place, a tax should yield a satisfactory
amount for the maintenance of a government.
In other words, the tax should be such that it
procures a considerable amount of revenue for the
expenditure of the government,
Secondly, the taxes should not obstruct and
discourage production in the short as well as in the
long run.
Con’t
(6) Canon of Elasticity
 The canon of elasticity implies that yields of taxes
should be increased or decreased according to the
needs of the government.
The government may need funds to face natural
calamities and other unforeseen contingencies.
 It may need funds to finance a war or for
development purposes.
The government resources can be raised quickly
only when the system is elastic.
Con’t
(7) Canon of Diversity:
The canon of diversity put forward by Bastable
implies that the tax system should be diverse in
nature.
In other words, in a tax system, there should be all
types of taxes so that everyone may be called upon
to contribute something towards the revenues of
the state.
Thus, the governments should adopt multiple tax
system.
Con’t

(8) Canon of Simplicity:

The canon of simplicity implies that a tax should
easily be understood by the tax-payer, i.e., its
nature its aims, time, of payment, method and
basis of estimation should be easily followed by
each tax-payer.
In other words, the tax imposed on the tax-payers
should be so simple that they are able to guess
easily the aim of its imposition and they are not
confronted with accounting, administrative or any
other difficulties.
Con’t

(9) Canon of Expediency:

This canon implies that the possibilities of
imposing a tax should be taken into account from
different angles, i.e. its reaction upon the tax-
payers.
Sometimes it is seen that tax may be desirable and
may be productive and may have most of the
characteristics of a good tax, yet the government
may not find it expedient to impose it, for example,
progressive agricultural income tax, but it has not
been imposed.
 So far in the manner it should have been imposed.
Con’t
EFFECTS OF TAXATION
Taxation these days is not used as means of raising
revenues only, but it is an important instrument for
achieving socio-economic objectives, such as,
regulation of consumption and production, controlling
booms and depression, promoting economic growth
and removing inequalities of income.
The economic effects of taxation may be good as well
as bad. Therefore, the government should not keep
only the revenue considerations in mind, but the
economic effects of taxation should also be
considered.
Con’t
To put it in the words of Dalton, “The best system
of taxation from the economic point of view is that
which has the best, or the least bad economic
effects.” Effects of taxation can be analyzed in
terms of production, distribution and stabilization.
Thus, in this we will discuss the economic effects
under the following three heads:
Effects of taxation on production
Effects of taxation on distribution
Effects of taxation on stabilization
Con’t
(1) Effects of Taxation on capacity to Work,
Save and Invest
(a) Capacity to Work:
 Capacity to work depends on the health and
efficiency possessed by the people.
 .Imposition of higher tax reduces the purchasing
power of the tax payer and his ability to obtain the
necessaries, comforts and luxuries of life.
Con’t
This effect is most strongly felt by the poorer
people. When the tax burden falls upon the poor, it
curbs the consumption of necessaries and comforts
which lowers the standard of living and thus
efficiency and ability to work of poor people is
adversely affected by taxation .
For the rich, however, the ability to work is not so
much affected by taxation because taxation on rich
may only curb his luxurious consumption and this
may not affect his efficiency and ability to work.
Con’t
Therefore, to maintain the health efficiency and ability
to work of the people, system of progressive taxation
should be duly implemented by the government.
b) Effects on the Will to Save:
in order to enhance the will of the people to save, the
government should provide tax incentives to the
people.
c) Effects on the Will to Invest:
People will also save and invest if they have full
knowledge about the avenues available for investment
and the tax incentives associated with each of these
channels of investment.
Con’t
Effects of Taxation on the Consumption and Pattern
of Production
High rate of tax on goods of harmful consumption
has a beneficial impact as the production of these
goods will be diverted to low-taxed essential goods.
Effects of Taxation on Distribution:
There are two aspects of an economy:
Income Generation and Income Distribution
Income generated in society if not distributed
properly will create inequality in the distribution of
income and wealth.
Con’t
It will give rise to the creation of two classes that is
the class of the rich and the class of the poor.
The gap between rich and poor will lead to class
conflict which may prove disastrous to the society.
Every government in the world tries to bridge this gap
by imposing higher taxes on the richer section of the
society and the proceeds realized from such taxes are
distributed among the poorer section of the society
by way of providing social amenities to them.
The effects of taxation on the distribution of income
and wealth among different sections of the society,
however, depend upon two factors: nature of taxes
and tax rates and kinds of taxes.
Con’t
Nature of Taxes and Tax Rates:
By nature/Methods/ taxation may be
 proportional,
 progressive or
regressive.
The nature of taxation also implies as how the burden of taxation is
distributed among different section of the community.
1.Proportional Tax:
If all the tax payers pay the same proportion of their income as tax.
2. Progressive Tax:
 if larger is the tax payers income, the greater is the proportion that
he pays as tax.
3. Regressive Tax:
if larger is the tax payee’s income, the smaller is the proportion,
which he pays as tax.
Con’t
a) Effects of Regressive Taxation on Distribution:
If regressive taxation is followed, the inequalities
may increase in the distribution of income and
wealth, as the burden of taxation will fall more
heavily on the poor than on the rich.
A toll-tax is regressive as the amount of the tax is
the same for the rich and the poor, while the utility
of money, which is paid in tax, is greater for the
poor than the rich.
A regressive tax thus tends to widen the gap of
inequality.
Con’t
b) Effects of Proportional Taxation on Distribution:
Under proportional taxation, inequalities would
continue as before, if the income remains the same.
However, if the income changes in unequal
proportions, the inequalities in income will increase.
the burden of taxation is higher on the poor than on
the rich.
c) Effects of Progressive Taxation on Distribution:
Under the progressive system of taxation,
inequalities would be reduced, because a higher
proportion of the income and wealth of the rich
would be taken away by taxes than that of poor.
Con’t
Hence, a sharply progressive tax system tends to
reduce inequalities in the distribution of income
and wealth.
Obviously, progressive system is desirable in order
to bring about a more equitable distribution
wealth.
Tax Rates:
A tax rate is the percentage at which an individual
or corporation is taxed
Con’t
While fixing the rates of taxes, progression should
be kept in mind.
Higher taxes should be imposed on the richer
section of society and revenue realized from the
rich should be utilized for the benefit of the poorer
section of the society by way of providing social
amenities to them.
In other words taxes should be progressive because
sharper the progression, greater is the tendency to
reduce inequalities.
Con’t

2) Kinds of Taxes
Whether the effect of taxation is progressive,
proportional or regressive in nature depends upon the
kinds of taxes.
There are two kinds of taxes:
Direct tax and Indirect taxes
a) Indirect Taxes and Distribution
The burden of indirect taxes, like taxes on commodities
is regressive in nature.
The commodities on which indirect taxes are imposed
are widely consumed by the poor and they have to
spend larger proportion of their income on such goods
than rich.
Con’t
That is, propensity to consume is higher for the poor
than that of rich.
Therefore, indirect or commodity taxes in general are
and regressive nature. Thus, inequalities of income and
wealth cannot reduced by these taxes.
b) Direct Taxes and Distribution
To bring about equitable distribution of income and
wealth, all taxes which fall heavily or exclusively upon
the richer section of society can have favorable
distribution effects.
 All direct taxes which are based on the principle of
progression and ability to pay may have desire
distributional effects.
Con’t
Effects of Taxation on Stabilization
Economic stability may be judged by the behavior
of prices. This does not mean that prices should
remain static.
Conversely there should be a normal rise in price
because a normal rise in price is a sign of healthy
economy.
Problem, however, arises whenever there are price
fluctuations.
These price fluctuations may be known as
abnormal economic situations prevailing in the
country.
Con’t

Every government tries to overcome these

problems through fiscal measures which is the
safest and the durable course adopted by any
government to control such situations.
Classification and choice of Taxes
1.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.
Con’t
 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, taxes on stamps
and registrations etc.
From the above discussion, it can be understood
that the direct taxes levied in Ethiopia take the form
of taxes on income and property.
Con’t
II. Indirect Taxes
Under indirect taxes, the impact and incidence fall
on different persons. It is not borne by the person
on whom it is levied and can be passed on to
others.
For example, when the excise duty is levied on the
manufacturer of cement, he shifts the burden of
tax to the consumers by raising the selling price.
Here the impact of excise duty falls on the
manufacturer and the incidence on the ultimate
consumers.
Con’t

The person who is required to pay the tax does not

bear its burden. Thus, indirect taxes can be shifted.
Differences between Direct and Indirect Taxes:
 Direct and Indirect taxes differ among themselves
on the following grounds:
1.Shiftability 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.
Con’t
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.
2. Principle of Ability to Pay:
Direct taxes conform to the principle of ability to
pay.
Con’t
 For example, now people having income above
Birr.600 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.
3. 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.
Con’t
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.
4. 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.
Con’t
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.
5.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.
Con’t
Moreover, the taxpayers need not follow any legal
formalities in the payment of tax. Thus, indirect
taxes are more convenient to them.
7. 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.
Con’t
8. 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.
The examples for direct taxes are income tax, rental
income tax, capital gain tax, agriculture and land
use tax etc.
Con’t
The examples for indirect taxes are customs duty,
excise duty, Turn over tax, VAT tax etc. in case of
Ethiopia.
Single and Multiple tax System.
A multiple tax refers to the tax system in which
taxes are levied on various items or bases.
The other advantages of multiple tax system are
that it is efficient in checking the tendencies of
frequent tax evasion.
It increases the tax revenue of the government. It is
more flexible than the single tax system.
Con’t
Multiple tax is a situation in which more than one
country or government department charges tax on
the same income.
 Multiple taxation is scaring away foreign investors,
as many of them are asked to pay different taxes to
different authorities in the country.
A single tax system presented many difficulties. It
proved inefficient in solving the real purpose behind
a good tax system. Consequently, economists now
widely acclaim multiple tax system.
Con’t

A modern economy is not one objective economy. It

tries to forge ahead simultaneously along the paths
of growth, equitable distribution of income and
wealth, economic stabilization, and soon:
since no single tax can be expected to help the
economy on all fronts, a choice for a multiple tax
system becomes expected. Different taxes
contribute to the attainment of different objectives.
Single tax System.
There is a single tax in a structure in which the tax
is imposed on one issue. There's only the one tax
that constitutes the source of public revenue.
Con’t
One basic form of a single tax is a poll tax, or a head
tax, which is levied on an individual regardless of
employment, property or occupation, etc.
There are difficulties in the definition and allocation
of an effective unified levy, in the calculation of the
rate structure, in the adequacy and development of
income and the implementation of national
priorities.
A single tax is a system of taxation based mainly or
exclusively on one tax, typically chosen for its
special properties, often being a tax on land value.
Con’t

The idea of a single tax on land values was

proposed independently by John Locke and Baruch
Spinoza in the 17th century.
A single tax occurs in a system in which the tax is
levied on one subject. There is only one tax which
constitutes the sources of public revenue.
One simple form of a single tax is the poll tax, or
the head tax which is imposed on a person
irrespective of his income, or wealth or profession,
etc.
Con’t

SHIFTING AND INCIDENCE OF TAXES

Meaning of Impact
The impact of a tax is on the person who pays the money in
the first instance. In other words, the man who pays the tax
to the government in the first instance bears its impact.
The impact of a tax is, therefore, the immediate result of
the imposition of a tax on the person who pays in the first
instance. It corresponds to what is often, but erroneously
called the “original incidence” or the “primary incidence”
of a tax. The impact of tax as such, denotes the act of
imposing.

Impact of a tax, therefore, refers to the immediate burden

of the tax and not to the ultimate burden of the tax.
Con’t
Meaning of Shifting
Shifting of a tax refers to the process by which the
money burden of a tax is transferred from one
person to another. Whenever there is shifting of
taxation, the tax may be shifted forward or
backward.
Meaning of Incidence:
Incidence of a tax refers to the money burden of a
tax on the person who ultimately bears it.
In other words, when the money burden of a tax
finally settles or comes to rest on the ultimate
taxpayer, is called the incidence of a tax.
Con’t
The incidence of tax remains upon that person who
cannot shift its burden to any other person, i.e.,
who ultimately bears it.
Thus, there are three distinct conceptions- the
impact, the shifting and the incidence of a tax,
which correspond respectively to the imposition,
the transfer, and the settling or coming to rest of
the tax.
The impact is the initial phenomena, the shifting is
the intermediate process, and the incidence is the
result.
Con’t

Distinction between Impact and Incidence.

The impact refers to the initial burden of tax while
incidence refers to the ultimate burden of the tax.
Impact is felt by the tax payer at the point of
imposition of the tax, while the incidence is felt by
the tax payer at the point of settlement or rest of
the tax.
The impact of the tax is felt by the person from
whom the tax is collected, while the incidence is felt
by the person who actually bears the burden of the
tax.
Con’t
Tax Evasion and Tax Avoidance:
Tax Evasion:-
Tax evasion is the general term for efforts by
individuals, firms, and other entities to evade the
payment of taxes by breaking the law.
Tax evasion means fraudulent action on the part of
the taxpayer with a view to violate civil and
criminal provisions of the tax laws.
It can be defined as “tax evasion implies the
activities involving an element of deceit, mis-
representation of facts, and falsification of
accounts including downright fraud”.
Con’t
Thus, it may be said that the tax evasion is tax
avoidance by illegal means i.e. tax evasion is against the
law and is an unsocial act.
Methods/Sources of Tax Evasion:
1.Omission to report taxable income.
One of the methods of tax evasion is the omission of
the tax-payer to report taxable income to taxation
authorities.
Under law, every individual, sole proprietorship,
partnership firms and corporations have to furnish
their income tax returns in time in case his or her total
income from all sources exceeds the maximum
exemption limit.
Con’t
 But many people do not supply any such information to
the govt.
They cheat their govt. by concealing facts with regard to
their income and wealth returns.
2. Maintenance of multiple set of books of accounts.
Many big business houses have been showing some
baseless transactions of expenditure to lower down
their tax burden.
Most of the business people are maintaining double set
of books of accounts by tax evaders.
One set of books of accounts is for personal use and
another for tax purpose.
Opening accounts under dummy names.
Con’t

Deduction of personal expenses as business

expense.
Some employees of big business houses regularly
deduct their personal expenses from office.
By treating personal expenses as business
expenses, people increase business expenses thus
lowering the profit of the enterprise.
3.Understatement of receipts.
Receipts received from credit sales add to the total
income of the business man. This addition to the
income due to credit sales, increases his tax liability.
Con’t

Hence, he takes such steps as to underestimate his

receipts so that he could reduce his tax liability.
4.Over-estimation of business expenses.
A person who evades the payment of tax,
overestimated his business expenses by showing
more salaries to employees as compared to actual
amount paid.
Tax avoidance :
Tax avoidance is method of reducing ones tax
liability by making use of loopholes in tax law.
Therefore, tax avoidance is not illegal.
Con’t
But whatever be the method an assesse adopts whether
it is avoidance or evasion, the consequences of his action
is the same i.e., loss of revenue to the state and increase
in the burden of the tax on other tax-payers.
Thus, tax avoidance is the art of escaping taxes without
breaking the law.
Examples for Tax Avoidance:
• Suppose a taxpayer’s total income exceeds the
maximum tax-free amount, then he has to pay the tax on
such excess amount. But if he invests the excess amount
in any of the approved schemes for which there is a
relief in the tax law, he can save on tax altogether.
Con’t
• An individual sells his let out house property (long-
term capital asset) for Birr.2,00,000 making a
capital gain of Birr 60,000. This capital gain would
normally be taxed. But, if he invests the sale
proceeds in a particular manner stipulated by law,
he need not pay any tax.
 Chapter-Five
Ethiopian Tax System
Income Tax Proclamation:
Proclamation No. 979/2016
Income tax is a very important direct tax. It is an
important and most significant source of revenue
of the government.
The government needs money to maintain law and
order in the country; safeguard the security of the
country from foreign powers and promote the
welfare of the people.
Con’t
It is the foremost duty of the government to bring out
welfare and development programs which will bridge
the gap between the rich and the poor.
All this requires mobilization of fund from various
sources. These sources may be direct or indirect.
What is Income Tax?
“Income” means every sort of economic benefit
including gains in cash or in kind, from whatever source
derived and in whatever form paid, credited or received.
“Taxable income” means the amount of income subject
to tax after deduction of all expenses and other
deductible items allowed under this Proclamation
979/2016 and Regulations 78/2002 issued.
Con’t

“Employee” means any individual, other than a contractor, engaged (whether on a

permanent or temporary basis) to perform services under the direction and control
of the employer
Income taxable under this proclamation shall include, but not limited to:
Income from employment:
Income from business activities:

A.
Income derived by an entertainer, musician, or sports person from his personal
activities;

B.Income from entrepreneurial activities carried on by a non-resident through a

permanent establishment in Ethiopia
Con’t
Dividends distributed by a resident company;
Profit shares paid by a resident registered
partnership;
Interest paid by the national, a regional or local
Government or a resident of Ethiopia, or paid by a
non-resident through a permanent establishment
that he maintains in Ethiopia;
Income from immovable property and appurtenances
thereto, income from livestock and inventory in
agriculture and forestry, and income from usufruct
and other rights deriving from immovable property is
much property is situated in Ethiopia.
Con’t

License fees (including lease payments, and royalties

paid by a resident or paid by a non resident through
a permanent establishment that he maintains in
Ethiopia.
The above sources of income are grouped under the
following four Schedules:
 The proclamation provides for the taxation of
income in accordance with four schedules.
 Schedule 'A' Income from employment;
 Schedule 'B' Income from rental buildings;
 Schedule 'C' Income from business;
 Schedule 'D' Income from other sources including:
Con’t
Determination of Employment Income (Schedule ‘A’)

A. Determination of Gross employment income: all

type of income like Basic salary, allowance,
overtime and bonus.
B. Taxable income
Every person deriving income from employment is
liable to pay tax on that income at the rate specified
in Schedule “A”, shown bellow. The first Birr 600 (six
hundred Birr) of employment income is excluded
from taxable income.
Con;t
• Employers have an obligation (Liability) to withhold
the tax from each payment to an employee, and to
pay to the Tax Authority the amount withheld during
each calendar month.
• In applying preceding income attributable to the
months of Nehassie and Pagumen shall be
aggregated and treated as the income of one month.
• Every person deriving income for employment is
liable to pay tax on that income at the rate specified
in schedule `A`, set out in Article 11. The first Birr 600
(six hundred Birr) of employment income is excluded
from taxable income.
Con’t
B. Exemptions
The following categories of income shall be exempted
from payment of income tax.
I. Income from casual employment
Income from employment received by casual
employees who are not regularly employed provided
that they do not work for more than one month for the
same employer in any twelve months period.
II. Contribution of retirement benefits by employers:
Pension contribution, provident fund and all forms of
retirement benefits contributed by employers in an
amount that does not exceed 15% (fifteen percent) of
the monthly salary of the employee.
Con’t
III. Income from Diplomatic and consular
representatives, and Other persons employed in any
Embassy, Legation, Consulate or Mission of a foreign
state performing state affairs, which are national of
that state and bearers of diplomatic passports or who
are in accordance with international usage or custom
normally and usually exempted from the payment of
income tax.
IV. Payments as compensation.
Payments made to a person as compensation or
gratitude in relation to:
Con’t

 Personal injuries suffered by that person.

The death of another person.
V. Allowable Deductions.
The following payments, made to an employee by an
employer, are allowed as deductions to determine
taxable income.
Reimbursed medical expenses
Transportation allowance (if provided in the
contract) federal 25% of basic salary or not more
than Br 800
Addis Ababa 15% of basic salary or not more than
Br 500.
Con’t

Hardship Allowance
Desert Allowance
Reimbursed traveling expense (incurred on duty)
C. Tax Rate
The tax payable on income from employment shall
be charged, levied and collected at the following
rates:
Con’t
Schedule A
0-600 Exempted Deduction
/Discount/
601-1,650 10% 60.00
1,651-3,200 15% 142.50
3,201-5,250 20% 302.50
5,251-7,800 25% 565.00
7,801-10,900 30% 955.00
>10,901 35% 1,500.00
Con’t
Methods of employment income tax computations.
There are two methods are used to compute
employment income tax.
Progression method
The amount of tax is calculated for each layer of tax
bracket by multiplying the given rate under
schedule A For each additional income.
Deduction methods
Income Tax=Taxable Income x tax rate – Deduction
 Deduction is computed by this formula
Con’t

Deduction = upper taxable income pervious tax bracket

tax rate of given bracket - cumulative threshold.
2.Tax on Income from Rental of Buildings (Schedule ‘B’):
Any income arising from rental of buildings is taxable
under schedule ‘B’. Rental income includes all form of
income from rent of a building and rent of furniture
and equipment if the building is fully furnished.

Gross rental income also includes any cost incurred by

the lessee for improvement to the land or building all
payments made by the lessee on behalf of the lessor in
accordance with the contract lease.
Con’t
Deduction
 Taxable income from schedule B income is determined
by subtracting the allowable deductions from the gross
income. Allowable deductions include the following:
A. For lessor that do not maintain books of accounts

 taxes paid with respect to the land and buildings being

leased; except income taxes; and
for taxpayers not maintaining books of account, one
fifth (1/5) of the gross income received as rent for
buildings furniture and equipment as an allowance for
repairs, maintenance and depreciation of such
buildings, furniture and equipment;
Con’t
B. For lessor that maintain books of accounts
 For taxpayers maintaining books of account, the
expenses incurred in earning, securing, and
maintaining rental income, to the extent that the
expenses can be proven by the taxpayer and
subject to the limitations specified by this
Proclamation, deductible expenses include (but are
not limited to) the cost of lease (rent) of land,
repairs, maintenance, and depreciation of
buildings, furniture and equipment in accordance
with Article 23 of this Proclamation as well as
interest on bank loans, insurance premiums.
Con’t
 building 5%, computer and related asset 25%,
furniture and equipment 20% and other asset 10%
of depreciation base.
1 Taxable income Taxa Rate Deduction.

2 0-1,800 Exempted 0
3 1,801-7,800 10% 180
4 7,801-16,800 15% 570
5 16,801-28,200 20% 1,410
6 28,201-42,600 25% 2,820
7 42,601-60,000 30% 4,950
8 Over 60,000 35% 7,950
Con’t

Accounting for Business Income Tax:

Meaning
Business means manufacture or purchase and sale
of a commodity with a view to make profit. It
includes any trade, commerce or manufacture or
any other adventure or concern in the nature of
entrepreneurial activity.
 It is not necessary that there should be a series of
transactions in a business and it should be carried
on permanently. Neither repetition nor continuity
of similar transactions is necessary.
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 Profit of an isolated transaction is also taxable
under this Schedule, provided that it is a venture in
the nature of business or trade. In this connection, it
is important that the intention of purchase or
manufacture should be sell at a profit.
Taxable Business Income.
Taxable business income shall be determined per
tax period on the basis of the profit and loss account
or income statement, which shall be drawn in
compliance with the Generally Accepted Accounting
Standards, subject to the provisions of this
Proclamation and the directives issued by the Tax
Authority.
Con’t
Business income tax or business profit tax is the tax
imposed on taxable business income /profit
realized from entrepreneurial activities.
it is charged on the profit of business enterprises
on their activities arising each accounting period or
tax year.
Category of Taxpayers
For the purposes of payment of business tax,
taxpayers are categorized into three namely:
Category “A”, Category “B”, and Category “C”
Con’t
Category “A” Taxpayer
Category “A” taxpayer includes;
Business that have separate legal personality (share
company, PLC and public enterprise) regardless of
their annual sales revenue.
Any company incorporated under the laws of
Ethiopia or in a foreign country and other entities
having annual turnover of more than Br 1 million.
Those who are categorized under “A” have to
maintain all records and account which will enable
them to submit a balance sheet and profit and loss
account.
Con’t
The following details are included the gross profit
and the manner in which it is computed , general and
administrative expenses, depreciation, and provisions
and reserves (together with the supporting vouchers).
Category “B” Taxpayer
 Category “B” taxpayers includes, unless already
classified in Category “A” Taxpayer , business with no
legal personality and those enterprises having annual
income of more than Br 500,000 and less than Br1
million ( i.e. Br 500,000 < sales < Br 1,000,000).
Category “B” taxpayers have to submit the profit and
loss statement together with the supporting
vouchers.
Con’t
Category “C” Taxpayer
Category “C” includes all taxpayers who are not
classified under the other two categories and
whose annual turnover is estimated at Br 500,000
or less.
Every businessman (except Category “C”) is
required to preserve all books of accounts and
other records and documents for a period of not
less than 5 years after the year of income to which
such books and documents relate.
Con’t
To determine the income tax liability of such tax
payer , standard assessment or presumptive method
shall be used .
Assessment or presumptive tax is fixed amount of tax
determined by estimation or best judgment. However,
if categories “C” tax payer maintain books of account,
they shall pay taxes on the basis of their books of
account.
Moreover the tax payer who drives income from
different source subjected to the same schedule shall
be assessed on the aggregate of such income. For
example if the individual has barberry and castle shop,
the income of the two business are aggregated.
Con’t
Tax payment Period
The fiscal year starts on Hamle 1 and ends on Sene 30. The
body can change the accounting year only with the
permission of the tax authority.
When the tax period of a body is changed (with the
permission); the period between the previous tax period
and the new period will be treated as a “transitional period”.
Allowable Deductions
In the determination of business income subject to tax in
Ethiopia, deductions shall be allowed for expenses incurred
for the purpose of earning, securing, and maintaining that
business income to the extent that the expenses can be
proven by the taxpayer and subject to the limitations
specified by this Proclamation.
Con’t
In order to determine taxable income under
Schedule “C” the following items of expenditures
are allowable for deduction.
1) Direct cost of producing the income such as the
direct cost of manufacturing, purchasing,
importation, selling and such other similar costs.
2) General and administrative expenses incurred
for earning, securing and maintaining the income.
such costs are salary of administrative personnel ,
utility cost, rental cost ,repair and maintenance and
e.t.c.
Con’t

3) Bad debt
4)Premium payable on insurance directly
connected with the business activity ;- insurance
premium directly connected with business activities
and against risk of damage or destruction of
business premises.
5) Expense incurred for the promotion of business
6) Commission paid for services rendered, provided
that the amount shall not exceed the normal rates
provided by other similar businesses or persons
Con’t
7) Any payment made by a branch, subsidiary or associated
company in
Subjected to the following two conditions;
The payment is made for the service actually received.
 The service was necessary for the business and could not
be performed by other person or by the business itself at
lower cost.
8) Salaries, wages or other benefit paid to the children of
proprietors or member of partnership. Subjected to the
following two conditions;
 a. such employees shall have the required qualification.
 b. the salary payable for such employs shall be equivalent
for the post.
Con’t
9) Salaries and other personal benefit paid to manager or managers of a private
limited company.
10) Interest expense, if the lending institution is recognized by NBE or a foreign
bank permitted to lend to enterprises in the country.

11) Depreciation expense

The following are the rates of depreciation permitted per the rule:

1) Building: 5% of the original cost. The cost includes the cost of acquisition,
construction, improvement, reconstruction and renewal.

2) Intangible Assets: 10% (straight-line basis).

3) Computers, information systems, software products and data storage

equipment: 25% (on a pooling system). Under pooling system the asset that has
the same or similar character pooled together and are called pooled asset. For
example projector, LCD, scanner ,flash disk e.t.c.
Con’t

4) All other business assets: 20% (on a pooling system)

All other depreciable business asset such as machineries,
vehicles furniture is pooled together. For assets for which the
pooling method is used, the rate is applied to the depreciation
base for the determination of depreciation.
Depreciation base is the book value of the asset on the opening
day of the tax period, increased by the cost of acquisition,
creation, renewal, etc during the period and reduced by the
sales price of the asset disposed during the period.
 Loss incurred during the period due to natural calamity and
other involuntary conversion will also be considered for the
computation of depreciation base. Any compensation received
for these purposes will be deducted from the book value.
Con’t

Non-allowable Deductions
All those expenses, which are not wholly or
exclusively incurred for the business activity, shall
not be allowed as deductions per the provisions of
law. Such expenses include:
1) Additional investment: an increase in the share
capital of a company or the original capital of a
registered partnership
2) Pension or provident fund contribution in excess
of 15% of the monthly salary of employees
Con’t
3) Business profit tax and input value added tax ;- but they can be
recovered through collection on sales.

4) Fines or penalty paid under violation of law

5) Losses that are not connected with the business activity

6) Losses recoverable by insurance

7) Entertainment expenses

8) Personal consumption expenses

9) Salary, wages, and other personal benefit paid to the partner, or
proprietor of an enterprise
Con’t
The following is the procedures for the declaration
of taxable income by taxpayers.
A) Taxpayers categorized as “A” are required to
declare their taxable income within four months
from the end of the tax period
B) Those taxpayers who are categorized as “B” are
required to declare their taxable income within
two months from the end of the tax period.
C) Category “C” taxpayers shall declare taxable
income within one month i.e. between July 07
and August each year .
Con’t
Assessment of Tax
Assessment is a tax review by a tax official of the tax
declaration and information provided by a taxpayer
and a verification of the arithmetical and financial
accuracy of the declared tax liability.
Pursuant to the proclamation, each taxpayer is
required to furnish the tax authority with all
information required for the assessment of income
tax including information about his operations, and
relationship with other bodies that may be
necessary for the declaration of income or for
supporting the books of accounts.
Con’t

The procedure for the assessment of business income

tax takes two forms:
A) Assessment by books of accounts, and
B) Assessment by estimation.
Assessment by books will be done for those who
maintain books of accounts (Category A and B). The
revenue authority makes assessment by estimation
when the taxpayers do not maintain the books or when
the submitted books are not acceptable. This is also
done if the taxpayer fails to declare his/her taxable
income within the time required. Tax, of those taxpayers
who have different sources of income, will be assessed
on the aggregate of all income.
Con’t

If the taxpayers keep no records, or if the income tax

authority does not accept the submitted books, or if the
taxpayer fails to declare tax within the time specified, the
income tax authority estimates tax by the use of certain
indicators. Category “C” should pay tax at fixed rate on
the income estimated by the income tax authority.
Tax assessors will be assigned by the tax office to
estimate the daily sales of the taxpayers. The estimates
will be done using the best of their judgment and
objectivity. The estimated daily sales will be converted to
annual income using the number of working days. Tax on
annual sales is determined on the basis of presumptive
value assigned to each activity.
Con’t
Provision for Loss Carry Forward
If a business incurs a loss in a year, that loss may be
set off against taxable income in the next three
years. If there is operating loss for more than one
period, earlier losses being set off before later
losses.
A net operating loss may be carried forward and
deducted only for two periods of three years.
However, the loss cannot be carried forward.
Penalties
The following penalties are provided in the
proclamation regarding business income tax.
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