UNIT 5

TAX THEORY AND PRACTICE

5.1 Introduction
Taxation is a crucial element of modern government, playing a pivotal role in revenue generation
and public finance. This unit explores the concept of taxation, delving into the theory and
practice of taxation in Ethiopia and globally. The unit is divided into five sections:
1. Concept of Taxes, Classification, Principles, and Objectives
2. Approaches to Tax Equity
3. Tax System and Structure in Ethiopia
4. Types of Tax and Tax Accounting in Ethiopia
5. Problems Associated with Taxation in Ethiopia
5.1.1 Definition and Terminologies in Taxation
Definition of Tax:- Tax, as defined by the Organization for Economic Cooperation and
Development (OECD), is the "compulsory, unrequited payments to general government." This
definition highlights that taxes are mandatory payments, enforced by legislation, and do not
involve a direct quid pro quo between the taxpayer and the government.
 Purpose of Taxation
Governments impose taxes for three primary purposes:
Cover the cost of administration
Maintain law and order
Defend the public
Additionally, taxes serve to raise revenue for funding economic infrastructure, healthcare,
transportation, education, and social welfare. Governments also use taxation to provide public
goods, redistribute income and wealth, and discourage the consumption/production of harmful
goods.
 Other Sources of Government Revenue
While taxation is a significant revenue source, governments also obtain funds through
borrowing, service fees, and money printing. However, taxation typically contributes to 90% or
more of total government receipts during peacetime.
 Terminology in Taxation
1. Tax Rate: The per-unit amount or percentage at which economic activities are taxed.
2. Tax Base: The level or quantity of an economic activity subject to taxation. Higher tax rates
can reduce the tax base.
3. Tax Incidence: The distribution of the tax burden among economic units (consumers,
producers, employees, employers). It determines who is legally responsible for paying the
tax.
4. Impact of Tax: The initial point of contact with taxpayers, felt by those with the first
statutory responsibility for payment.

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5. Effect of Tax: Responses from taxpayers and the economy to the imposition and collection
of taxes, influencing various aspects of the economy.
In summary, taxation is vital for government functions, and understanding its terminology and
principles is essential for comprehending its impact on individuals, businesses, and the broader
economy.
5.1.2. Objectives of Taxation
a) Minimize Income and Wealth Inequalities:
 Governments use taxes as a tool to address economic disparities and promote social
equality.
b) Stabilize the Economy:
 Taxation is employed to regulate economic fluctuations, contributing to overall economic
stability.
c) Discourage Consumption of Harmful Products:
 Taxes can be strategically imposed to discourage the consumption of goods deemed
harmful to individuals or society.
d) Provide Incentives for Capital Formation in the Private Sector:
 Tax policies can offer incentives to encourage private sector investment and capital
formation.
e) Reduce Regional Imbalance:
 Through taxation, governments may aim to reduce economic disparities among different
regions.
f) Enhance Standards of Living:
 Tax revenues can be utilized to fund programs and initiatives that improve the overall
quality of life for citizens.
g) Utilize Scarce Resources for Essential Goods:
 Taxation is a means to allocate resources efficiently and direct them towards the
production of essential goods and services.
h) Minimize Unemployment and Encourage Exports:
 Tax policies may be designed to support job creation and stimulate export-oriented
industries.
Role of Taxation:
 Taxation plays a significant role in resource allocation, distribution, and re-distribution to
achieve macroeconomic and social goals.
5.1.3. Principles of Taxation
Adam Smith's Principles (Wealth of Nations, 1776):
1. Proportional Contribution:
 Citizens should contribute to the government based on their respective abilities
and revenues enjoyed under state protection.

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 2. Certainty and Clarity:
 Taxes should be clear, certain, and easily understandable regarding time, manner,
and quantity.
3. Convenient Collection:
 Taxes should be collected at a time and in a manner convenient for the
contributors.
4. Minimum Burden on People:
 Taxes should minimize the impact on individuals, taking as little as possible from
their pockets beyond what contributes to the public treasury.
5. Economy in Collection:
 The cost of collecting taxes should be minimized, following the principle of
economy.
6. Fiscal Adequacy:
 Tax systems should generate sufficient revenue to prevent the need for deficit
financing.
Modern Principles:
 Equity, fairness, certainty, convenience, economy, flexibility, simplicity, diversity, and
buoyancy are crucial aspects of a well-designed tax system.
Conclusion:
 The principles of taxation guide the formulation of tax policies to ensure an efficient, fair,
and effective system that aligns with economic and social objectives. Understanding
these principles is essential for comprehending the broader economic impact of taxation.
5.1.4. Characteristics of a Good Tax System
Compulsory Nature:
 Taxation is compulsory, and non-payment is considered a criminal offense.
Collective Use of Revenues:
 Tax revenues are intended for collective use, benefiting both payers and non-payers.
Regular and Periodic Basis:
 Taxes are paid on a regular and periodic basis with known due dates.
Non-Discriminatory:
 Taxation is levied on all individuals without discrimination, based on their ability to pay.
 Characteristics of a Good Tax System:
Simple, Financially Adequate, and Elastic.
Broad-Based:
 Levied not only on income but also on property and commodities.
 Administratively Efficient.
 Balanced and Harmonious.
 Reduction of Economic Inequalities.
 Ensuring Economic Stability.
 Enhancing National Income or Standard of Living.

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  Instrument of Economic Growth.
 Socially Advantageous.
 Optimum Allocation of Resources.
 Additional Criteria:
 Adequate revenue yield, equitable distribution of the tax burden, minimal interference
with economic decisions, fair and non-arbitrary administration, and understandable to the
taxpayer.
5.1.5. Classification of Taxes
 Direct Taxes:
 Imposed on the same person who earns the income.
 Computed based on the taxpayer's ability to pay.
 Types of Direct Taxes:
i. Income Tax:
 Imposed on income generated by individuals and businesses.
ii. Transfer Tax:
 Commonly levied on real estate, including trusts and financial accounts.
iii. Property Tax:
 Charged on properties like land and buildings, used for maintaining public service.
iv. Capital Gains Tax:
 Levied when selling assets such as stocks, real estate, or a business.
Indirect Taxes:
 Impact and incidence on different persons.
 Examples of Indirect Taxes: Value-Added Tax (VAT), Excise Tax, Turnover Tax (TOT),
Surtax, Customs Duty, Stamp Duty.
5.1.6. Major Categories and Sources of Taxes
Ethiopia:
 Taxes classified as Schedules, including income from employment, rental of buildings,
business income, and other incomes.
United Kingdom:
 Main types of taxes:
 Income Tax, National Insurance Contributions, Consumption Tax (VAT), Excise Duties,
Corporation Tax, Stamp Duty, and "Sin Tax."
United States:
 Five common types of taxes:
 Earnings (Payroll Tax)
 Individual Income (Income Tax, Capital Gains)
 Corporate Income (Corporate Income Tax)
 Wealth (Property Taxes, Estate Taxes)
 Consumption (Consumption Tax, Sales Taxes, Excise Tax).

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 Conclusion:
 Understanding the characteristics, classification, and major categories of taxes is essential
for comprehending the diverse ways governments generate revenue and achieve
economic objectives.

5.2. Approaches to Tax Equity

5.2.1. Benefits Approach
 Principle:
 Tax system based on the benefits individuals receive from public services.
 Objective:
 Distribute the tax load among individuals and groups in proportion to the benefits
derived from public services.
 Advantage:
 Links tax equity with public budget expenditure.
 Challenges:
 Difficulties in attributing benefits to certain government spending areas (e.g.,
defense, police) make application complex.
5.2.2. Ability-to-pay Approach
 Principle:
 Tax levied based on each taxpayer's ability to pay.
 Focus:
 Distributive nature of taxation.
 Key Questions:
 How to measure ability to pay?
 How to determine fair tax rates based on different abilities to pay?
 How to compare the economic status of individual taxpayers?
 Equity Concepts:
 Horizontal equity: People in the same circumstances pay the same taxes.
 Vertical equity: Unequal individuals are treated unequally.
Types of Taxes Based on Impact:
 Progressive Tax:
 Higher incomes pay a higher share of taxes compared to lower incomes.
 Proportional Tax:
 Everyone pays the same share of taxes regardless of income level.
 Regressive Tax:
 Higher incomes pay a lower share of income in taxes than lower incomes.
5.3. Tax System and Structure in Ethiopia
 Historical Overview:
 Introduction of Income Tax:- In 1944, Emperor's decree required peasants to pay one-
tenth of agricultural products as tax.
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  Evolution of Tax Regimes:- Tax regimes changed with shifts in governments.
 Current Structure:
 Government Agency:- Federal Ministry of Revenues (MoR) responsible for tax
collection.
 Legal Framework:- Proclamation No. 33/1992 and FDRE Constitution (1995) define
revenue-sharing principles between federal and regional governments.
 Revenue-Sharing:- Federal government levies taxes on reserved revenue sources, and
Regional states levy and collect taxes on state-reserved revenue sources.
 Constitutional Status:- Ethiopia consists of 11 regional states and 2 autonomous
administrations (Addis Ababa and Dire Dawa Cities).
Conclusion:
Understanding the principles of tax equity and the structure of the Ethiopian tax system is crucial
for comprehending the dynamics of revenue collection and distribution in the country. This
knowledge aids in evaluating the fairness and effectiveness of the tax system.

5.4. Types of Income Tax in Ethiopia (According to Tax Proclamation No.

286/2002)
 Schedules of Income:
a) Schedule A: Income from Employment
 Taxed at rates ranging from 10 to 35%.
 Final tax; employees not required to declare income.

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b) Schedule B: Income from Rental of Buildings
 Imposed for each tax year on persons renting out buildings.
 Taxable income is gross rental income reduced by allowed deductions.
c) Schedule C: Income from Business
 Business income tax imposed for each tax year.
 Taxable income is total business income reduced by deductions.
d) Schedule D: Other Income
 Includes royalties, income from services outside Ethiopia, dividends, interest, and non-
business capital gains.
e) Schedule E: Exempt Income
 List of exempted income items, including medical treatment, hardship allowance, salary
to domestic servants, and others.
 Indirect Taxes in Ethiopia
a) Value-Added Tax (VAT):
 Introduced in 2003 with a standard rate of 15%.
 Applied on every taxable transaction by registered persons.
 VAT is destination-based, only taxing the consumption of goods and services.
b) Turnover Tax (TOT):
 Equalization tax for those not registered for VAT.
 Rates vary based on services rendered locally.
c) Excise Tax:
 Imposed on selected goods, including luxury items and basic goods.
 Applicable to 19 groups and 378 goods, with rates ranging from 5% to 500%.
d) Surtax:
 Additional 10% tax on imported goods (except specified items).
 Ministry of Finance has authority to modify the list of exempt goods.

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e) Pension Contribution:
 Employer (11%) and employee (7%) contributions to the Private Organizations Pension
Fund.

f) Withholding Tax:
 Deducted at a rate of 2% on domestic transactions by all bodies and specified sole
proprietor businesses.
g) Stamp Duty:
 Imposed on services by affixing seals to documents.
 A tax collected through the sale of government-issued stamps.
h) Customs Duty:
 Tax on imported or exported goods, serving as a trade barrier.
 Used to discourage or control imports, protecting domestic industries.

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 Tax Accounting in Ethiopia
 Tax accounting involves calculating financial statements and figures used for tax
calculations.
 Individuals, businesses, and entities use tax accounting.
 Individuals in Ethiopia often have income tax deducted by employers.
 Businesses maintain up-to-date financial records to determine tax liabilities.
Understanding the types of taxes and tax accounting practices is essential for individuals and
businesses to comply with Ethiopian tax regulations and optimize their financial management.

5.5. Challenges in Tax Administration

 Global Criticisms
 Complexity and Difficulty:
 Tax systems criticized for their administrative complexity and difficulty for
taxpayers to understand and comply.
 Costs and Unreported Transactions:
 Complexity and difficulty may lead to increased costs for taxpayers.
 Encourages growth of unreported transactions (tax evasion) and demand for tax
shelters (tax avoidance).
 Modernization in Developed Countries
 Efficiency Improvement:
 Developed countries focus on modernizing customer services for tax
administration efficiency.
 Emphasis on new management techniques with concepts of "client orientation" or
"customer orientation."
 Challenges in Developing Countries (Including Ethiopia)
 Diverse Problems:
 Complexity of the tax system, perception of corruption, compliance costs, fairness
perception, and tax knowledge pose challenges.
 These problems fall under tax compliance and bureaucracy in tax systems.
 Tax Compliance Issues
Tax Compliance
 Definition:
 Degree to which taxpayers comply with tax laws.
 Forms of Non-Compliance:
 Tax avoidance: Arranging affairs to minimize tax burden legally.
 Tax evasion: Falsifying information on a tax return or not filing, which is illegal.
Tax Avoidance and Tax Evasion
 Tax Avoidance:
 Legal, involving the use of tax code provisions to reduce tax obligations.

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 
Example: Reducing tax burden through exemptions, deductions, or incentives.
 Tax Evasion:
 Illegal, involving falsifying information on a tax return or not filing at all.
 Rooted in underground economic activities due to illegality or high marginal tax
rates.
 Additional Challenges in Tax Administration
 Steadily Growing Workload:
 Tax administrations face increasing workload challenges.
 Complex Fiscal Legislation:
 Difficulty in understanding complex fiscal legislation.
 Taxpayer Attitude and Non-Compliance:
 Attitude of taxpayers and the degree of non-compliance.
 Improving Customer Service:
 The need to enhance customer service in tax administration.
 Reducing Costs and Efficient Management:
 Necessity to reduce costs of tax assessment and collection.
 Demand for efficient and effective tax management.
4. Unit Summary
 Taxes are compulsory payments to the general government, imposed for common goals.
 Good tax systems are equitable, efficient, easy to administer, non-distortive, and
understandable.
 Taxes categorized as direct and indirect, with progressive, proportional, and regressive
taxes denoting their impact.
 Challenges in tax administration include complexity, compliance costs, fairness, and
global criticisms.
 Tax compliance involves legal (avoidance) and illegal (evasion) strategies, posing
challenges for tax administrations.
 Additional challenges include workload, legislation complexity, taxpayer attitude, and the
need for improved customer service and efficient management.

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