1.

0 TAXATION THEORY

3.3 PUBLIC RECEIPT AND PUBLIC REVENUE

We have so far seen the origin of the concept of state; the emergence of modern state justification for
state and activities state undertakes to achieve its object (the purpose for which it’s formed in a society
of men). We therefore understand that the state may require vast economic resources to perform the
activities so required to achieve its objects. Therefore let’s examine how the state obtains the economic
resources

PUBLIC RECEIPT

This concept refers to the total amount of economic resources received by state and at its disposal for
expenditure. Public receipt consists of:

(i) Public revenue

(ii) Public debt
(iii) Capital receipts
(iv) Donations
(v) Escheats
(a) Public revenue/ revenue receipts
These are routine and recurrent receipts by state. It includes both tax revenues and earned
revenues. The following are common sources of public revenue:
(i) Taxes: a compulsory levy payable to state by an economic unit with no entitlement to
receive a direct and opposite quid-pro-quo.
(ii) Licenses: payment for privileges conferred by state to some citizen’s e.g. to import
certain goods, to operate mobile phone services, undertake some trades.
(iii) Fees: is part payment for cost of service rendered e.g. school fees in public schools and
colleges, right to use public roads, registration births, marriages
(iv) Prices: market price paid for goods and services rendered by state. Prices are voluntary
and optional
(v) Dividends and interest: income from state investments such as interest dividends and
profits
(vi) Special assessment: payment levied certain members of community who are
beneficiaries of certain public project e.g. land owners in a specific locality to help fund
infrastructural improvement in that neighborhood.
(vii) Fines: payment to state as a punishment for breach of the law. Its intended to deter
breaches of the law while raising revenue
(viii) Royalties: a payment to state for the privilege to use a natural resource within the
states jurisdiction e.g. mineral mines, forest, game reserve,
(b) Public debt
This refers to funds borrowed by the state from the public (corporations and individuals). Public
borrowing transfers the purchasing power from the public to the state. Its usually undertaken by

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 the treasury through the central bank. The tools used include treasury bonds and treasury bills.
This category of receipt consists of short term to medium term borrowings. The state can also
borrow externally or internally
(c) Capital receipts: receipts arising from management of long term debt and equity investments
or asset portfolio. At any given time the state maintains a portfolio of assets consisting of debt
securities, equity securities, and real assets. Some of these assets can be converted to cash for
use in further investment or in recurrent expenditure. The conversion yields cash classified
under capital receipts
(d) Donation/grants/gifts
These are revenues received from private citizens who donate to state for one reason or
another and grants to specific projects of state by friendly foreign governments or from central
government to local government. Donation can be to state or state agency for specific projects
(e) Profit from money minting. Minted currency is brought to circulation ether as replacement of
withdrawn coins and notes or as increase in volume of supply. The increase component is spent
by state and constitutes public receipt
(f) Escheats: claim by state of a deceased person’s estate. Occurs if an heirless person
bequeaths state or dies intestate.

1.4.0 Taxation: CHARACTERISTICS, OBJECTIVES, AND CANONS

A tax is a compulsory levy payable by an economic unit to the state without any corresponding
entitlement to receive direct quid-pro-quo from the government (Bhatia, 2004). A tax is a
compulsory contribution imposed by a public authority irrespective of the exact amount of
service rendered to the rate payer in return (Dalton,); taxes are general compulsory
contributions of wealth levied upon persons natural or corporate to defray the expenses
incurred in conferring common benefits upon residents of a state(Dewett, 2005)

From the foregoing definitions the following tax characteristics are evident:

(i) Its levied unilaterally by state; consent or will of rate payer is not necessary
(ii) Its compulsory; non-payment results in use of violence/ retribution
(iii) Its no direct and opposite quid pro quo

1.4.1 Objectives of taxation

When atax is levied the tax base must be prescribed. Tax base refers to the legal description of the
object with reference to which the tax is payable.eg tax base of income tax is income as described in
cap470; the tax base excise duty is production, packaging, processing Etc of specified goods. The
purpose of taxation is best analyzed after observing the different types of taxes levied by state and the
activities the state undertakes to achieve its object;

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The fundamental objective of taxation by state is to raise revenue. The state levies the following
categories of taxes:

(i) Income taxes: income received by individuals and corporations

(ii) Expenditure taxes: expenditure by individuals and corporations
(iii) Property and capital transactions; taxes on wealth and wealth transfers such as estate duty,
wealth tax, gift tax, house tax, land revenue, stamp duty , registration fees, inheritance tax,
generation skipping tax
(iv) Taxes on commodities and services: taxes on production, sale, purchase , transportation,
storage , and consumption of goods and services

Taxation has a negative effect on behavior of tax payers: when levied on goods and services they
increase the price and reduce the purchasing power of the rate payer thus restricting the amount that
can be purchased.

This characteristic of taxation is applied as an economic tool by state in modulating activities in

the economy:

To use this characteristic taxation can be levied selectively on;

- Activities
- Income generation activities
- Portfolio of wealth and wealth transfer methods

Therefore taxes are levied by state not only to raise revenue but also to help achieve some desired soci-
economic effects.

The state levies taxes for the following reasons therefore:

(a) Raise revenue; this is necessary to fund its numerous activities

The state requires revenue for expenditure; the state needs to fund supply of public goods and services
such as:

(i) Provision of economic infrastructure such as roads; water, electricity telecommunication

infrastructure motive power
(ii) Provision of social infrastructure; schools, colleges, corrective facilities
(iii) Medical services
(iv) Public administration
(v) Military and police services
(vi) Judicial services
(vii) Capital for investment

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 (b) Optimum resource allocation: resources are allocated in an economy between ;
(i) Savings and investment on one hand and consumption
(ii) Different geographic areas of the state
(iii) Different economic sectors; agriculture, commerce, service, Manufacturing industry

In a laissez-faire/ free market economy resource allocation is entirely done by market forces (supply and
demand). In a centrally planned economy the job is performed by state. In mixed economies such as
Kenya the allocation of resources is partially done by state and by price mechanism. In such cases the
state intervenes either indirectly thro taxation policies or directly by participation in the market thro
supply of goods and services thro investment in supply of goods and services to optimize resource
allocation. It’s thought that market imperfection results in less than optimum resource allocation by
price mechanism. Income and wealth disparities between persons and between geographic areas results
in imbalanced resource allocation. These imbalances can only be addressed thro conscious actions of
state.

(c) Redistribution of income and wealth.

In a free market economy the gap between the rich and the poor is likely to widen unless deliberate
policies are implemented to reduce it. The reason being, free enterprise favors unfettered return on
capital. Those lacking capital receive wages which is often minimal. Income and wealth disparity
polarizes society. States redistribute income and wealth to reduce animosity between social classes. This
strategy is achieved thro progressive income and expenditure taxes, and various wealth taxes seen
earlier

(d) Protection of local industries

Customs duty is sometimes imposed to protect local industries against unfair competition from foreign
companies. Export of raw materials may also be taxed to improve supply of raw materials for local
industries. Example exportation of scrap metal is restricted. Importation of sugar is taxed. Similarly
importation of fully assembled motor vehicles is more taxed than importation of CKD kits for local
assembly. This is aimed at protecting local motor vehicle assembly industry. Sugar and rice imports are
either restricted or heavily taxed to support local production

(e) Social welfare

Taxation may be used as a tool to maximize social welfare. Goods and services that are detritus to
society may be discouraged thro heavier taxation than goods and services that promote social and
economic wellbeing of a greater membership of society or even the goods and services may be untaxed.
For example in Kenya two taxes are particularly used for this purpose: excise duty and VAT; alcohol,
cigarettes and gambling attract very high rates of tax (excise duty), sanitary towels, and liquefied
petroleum gas (LPG) and kerosene attracts low taxes. In fact some items are zero rated for VAT.

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 (f) Economic stability

Market Economic systems are subject tendency to disequilibrium as we saw earlier. Equilibrium requires

E≡O≡Y

Where E=C +I , Y =C +S this requires I=S

But in market economic systems I, S are independent and may not be equal.

I≠S dc/dy =1 - ds/dy dc/dy = marginal propensity to consume < 1

[ increase in income results in less than proportionate increase in consumption expenditure hence

E < Y]

The economy therefore tends recession. Taxation as part of fiscal policies of state can be applied to
reduce disposable income and hence slow down progress towards boom and similarly applied in the
reverse to increase disposable income to delay or reduce slide into recession. Taxes applied to this
function focus on consumption expenditure, income, savings, and investment. Economic stabilization
function aims at fairly stable level of economic activities reducing misery and suffering associated with
depression and wide disparities in real income associated with boom. It also enhances predictability of
macro-economic variables in the future which promotes investment, economic growth and economic
development

1.4.2 CANONS OF TAXATION (PRINCIPLES OF A GOOD TAX SYSTEM)

Taxes are levied by state for a number of reasons as seen earlier. The objectives range from

(i) social to
(ii) economic reasons besides
(iii) raising revenue

- Taxes have social and economic effects when levied

- And when tax revenues are spent

A good tax system should not only raise revenue

- Effectively
- Efficiently and
- Economically

But also help achieve

- Economic growth , stability and development and

- Social harmony and progress

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For a tax system to achieve it s objectives as aforesaid it must possess the following characteristics also
known as canons of taxation:

(a) Canon of equality

“The subjects of every state ought to contribute towards the support of the government as nearly as
possible in proportion to their respective abilities, that is, in proportion to the revenue they respectively
enjoy under the protection of the state” (Adam Smith: the wealth of Nations 1786).Equality does not
mean equal amounts.

Ability to pay may be inferred from wealth, income or expenditure.

Proportional contribution may be interpreted to mean proportionate sacrifice or

income/wealth/expenditure

When the economic concept of diminishing marginal utility is applied to wealth/ income / expenditure
proportionate sacrifice of utility translates into progressive rates of taxation.

Those with higher income/ wealth/ expenditure need to sacrifice a higher amount to yield the same
proportionate loss in utility as those with lower income/ wealth/ expenditure . the canon therefore
proposes

(i) Taxation based on ability to pay

(ii) Proportional tax or
(iii) Progressive taxation
(b) Certainty

“The tax which each individual is bound to pay ought to be certain, and not arbitrary. The time of
payment, the manner of payment, the quantity to be paid ought all to be plain and clear to the
contributor and to every other person” uncertainty results in power transfer to tax collector who may
use it to punish a tax payer at will or to ex tract perquisites or personal gain. It also results in feeling of
unfairness which may result in resentment evasion or avoidance.

It supports the old adage “an old tax is no tax” tax payers are certain about it and have made necessary
adjustments. Its effects are not felt. The state also needs to be certain about the tax revenue amount
and timing for its financial planning.

(c) Convenience

“Every tax ought to be levied at the time or in the manner in which it is most likely to be convenient to
the contributor to pay it” whereas certainty requires timing and manner of payment to be certain
convenience requires the timing and manner of payment to be convenient

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Manner of payment and timing: by cash, by check, at a local bank ranch, by installments, anytime before
a fixed date etc

In Kenya a number of measures have been taken to make taxation convenient: income tax is paid
through installments and mostly at source; salaried individuals pay through PAYE, those earning interest
and dividends and a number of payments e.g rent or professional services do business in Kenya but are
foreign based pay thro’ WHT. All persons doing business, pay tax on business income thro’ quarterly
installments. VAT is remitted before 20th of each calendar month for prior month by collectors and is
paid when taxpayer is ready to make a purchase, similar to excise duty and import-duty

(d) Economy

“every take ought to be so contributed as both to take out and keep out of pockets of the people as little
as is possible over and above what it brings to public treasury of the state”. In brief the cost of collecting
the tax should be minimal. The cost of collection includes tax administration costs to state and costs of
compliance by citizens.

The tax should also promote the economic welfare of society. It should retard production detritus goods
while enhancing the production of goods and services that promote social and economic welfare of
citizens. It should not result in the converse effects. Its perceived that it’s not possible for a tax to be
economically neutral

(e) Productivity/ fiscal adequacy

A good tax system should generate adequate tax revenues to cover state expenditure needs. The state
ordinarily should be subject to revenue deficits resulting in financial embarrassment. Taxes on the other
hand should not be excessive resulting in adverse effects in the economy such as retarding production.

This principle suggests a few taxes yielding adequate tax revenue is better than a battery since each
additional tax has negative effects. It must however be noted that a few taxes would imply
concentration of taxation on a few individuals; others escaping the tax net which results in inequality. An
optimum level is to be obtained. Kenya uses mainly three taxes: VAT, income-tax, and excise-duty. It
also maintains supportive taxes such as PIT, WHT, import-duty, turnover tax to net in more tax payers

(f) Elasticity

Principle of elasticity connects tax revenues to state expenditure needs. As state expenditure needs
grow tax revenues ought to grow. Emergency expenditure needs of state should be adequately provided
for under the tax system by simply making a small adjustment. I.e. an elastic system is one that can
easily adjust tax revenues to changes in state revenue needs. E.g. tax system where taxes are indicated
in percentage; a change in the percentage alone adjusts the tax revenues example VAT income tax and
excise duty

(g) Simplicity

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“A system of taxation should be simple, plain and intelligible to the common understanding” this canon
eliminates ambiguity which creates room for extortion. Ambiguity also increases the cost of compliance
since tax payers have to hire agents.

(h) Diversity

A single tax is thought to be unsatisfactory because it is easy to avoid and evade leaving the tax burden
on a few citizens and increasing the rate of taxation. A battery is believed to be satisfactory because it
becomes difficult to evade and avoid. It also brings a large number under tax net therefore reducing the
tax rate per tax, and overall per person. The battery should contain diversity to net diverse people. Care
is take to increase diversity within economic limits

(i) Effectiveness/ achievement of social and economic objectives

Taxation is an objective driven exercise. The numerous objectives of taxation must be addressed even as
these other characteristics are sort. The old school economic theory of neutrality of taxes no longer
holds. This is substituted with effectiveness: the tax system ought to achieve what it purports to seek.
I.e. achieve fiscal accuracy.

2.0 TAX BURDEN DISTRIBUTION

In order to examine how the burden of taxation is to be distributed we need to recap the following facts
about a tax:

(a) A tax is a compulsory payment with no quid-pro-quo

(b) A tax levied on one economic unit may be shifted to another unit via prices
(c) Taxes have effects which diffuse in the economy

Tax burden refers to the harmful effects of a tax (Bhatia,). Two dimensions of the harmful effects may be
identified: money burden and real burden.

Money burden refers to reduction in disposable income of the taxpayers. The money burden can
further be divided into two:

i. Direct money burden: actual amount paid to the treasury

ii. Indirect money burden: incidental expenditure related to tax compliance

Real burden refers to the harmful effects in terms of benefits lost when a tax is imposed. Example,
reduction in production, employment, and consumption by households. It’s the welfare the community
as a whole losses. Ie welfare sacrificed to state when a tax is levied.

Tax burden distribution seeks to determine who should be the point of impact of a tax and how much
should be levied at that point of impact?

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The study of how tax burden ought to be distributed has occupied human thought for many years. Adam
smith(1786) first asserted that “ the subjects of every state ought to contribute towards the support of
the government , as nearly as possible, in proportion to their respective abilities,..” Adam Smith(1786)
exerted himself to the basis of apportioning tax liability of the community to citizens of state and
possibly came up with one base:

(1) Ability to pay

For he said “…, in proportion to their respective abilities …”

This ability he measured on the basis of “revenue received and enjoyed under protection of state”.
Other economists have critically examined the issue. In their discourse, they proceeded as follows:

To undertake the analysis the following assumptions were made

(a) No tax shifting

(b) No effects of a tax other than money burden
(c) There is no government expenditure or its effect on tax burden is assumed nill.
(d) The objective of taxation is purely to raise revenue

Based on these assumptions and the definition of tax it’s possible to develop theories (broad
generalization about taxation) that guide distribution of tax burden:

(1) There need not be any relationship between tax paid and benefits received from state activities
(2) There is a link between tax liability and state activities
(3) There need not be any link between tax liability and activities of state

From the broad generalization specific theories have been developed explaining how the tax burden
ought to be distributed:

(a) There need not be any relationship between tax paid and benefits received from state activities
(1) Socio-political theory
(2) Expediency theory
(b) There is a link between tax liability and state activities
(1) Benefits received theory
(2) Cost of service theory
(c) There need not be any link between tax liability and activities of state
(1) Ability to pay theory

Let us now examine these theories in details

(1) EXPEDIENCY THEORY:

- This theory puts emphasis on practicality of a tax and not rationale.
- The purpose of a tax is to raise revenue and all other pretended objectives are secondary or
irrelevant

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- Only taxes that can be levied and collected are relevant. Those that will arouse opposition or
evasion are not necessary
- To some extent this theory is applicable. Its ridiculous to levy taxes that cannot be collected
- It cannot help state in selecting one between taxes that can be collected. Its also possible that
those affected by any tax would allege impracticality of the same.

(2) SOCIO-POLITICAL THEORY

- According to this theory, society consists of individuals but it’s much bigger than the sum total of
individual members. Therefore social and political considerations outweigh individual
considerations when making decisions. Taxation therefore should be used to solve social and
political problems without undue consideration of individual interests. Taxation in particular
should be used to address socio-economic inequalities
- Private property and inheritance occur because of state policies resulting in wealth inequality
and not due to god given rights
- This theory underlies fiscal policies in many a modern state: taxation is used as a fiscal tool for
many socio-economic objectives of state as seen earlier.
- It also proposes steeply progressive taxation
(3) THE BENEFITS- RECEIVED THEORY
- This theory assumes that there is a contractual relationship between tax payers and the state
- The state provides services to its citizens who are under obligation to provide revenue to state
in proportion to the benefits received
- This theory derives its foundation from social contract theory of state. The relation between
state and citizens is contractual and from the contract citizens provide economic resources in
return for services as quid pro quo
- The state provides two types of goods:
1. Private goods
2. Public goods
Private goods
These are divisible goods, and to which the principle of exclusion can apply
Public goods
These are goods that are not divisible and the principle of exclusion cannot
apply
- Private goods are supplied in exchange for prices, or fees and the taxpayer may opt not to
consume the product
- Public goods are supplied to the whole population by state and every citizen contributes to
state revenue in proportion to benefits received. The contribution is compulsory
- Issues arising in practice:
 Who are the beneficiaries of state services?
 How much benefit did each receive?

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- Wealth and income are accepted as indicators of demand for state services although dissenters
say the converse could be true: the amount of benefit derived from state services however is a
function of the following:
 Received Amount of services
 Distribution of the services to other society members
 Attitude of the beneficiary to the services
- Individual benefit received is therefore difficult to measure in practice for public goods
- Income and wealth parameters provide a junction between ability to pay and benefits received
 Income measures ability to pay taxes
 Income and wealth also provide excellent proxy measure of amount of
protection one needs from state to enjoy his wealth and income. This is
particularly true where there is wide disparity in income and wealth
- This theory would propose proportional taxation if current income /wealth is a proxy measure of
benefits received
- If the economic law of diminishing marginal utility is applied to income/wealth, it proposes
progressive taxation on account of proportional sacrifice of benefits
- Another weakness of the theory is the supposition of voluntary compliance with taxation. In
practice this assumption is not tenable and is inconsistent with definition of tax. One cannot
declare benefits received from state services, preferences, nor be permitted to opt out of
taxes and benefits (public goods)
- However where practical, like incase of local infrastructural improvements, it can apply to
inform special assessment.
- Summary of opposition to the theory
(1) Difficulty in measurement of benefits received by individuals
(2) Contradiction with definition of tax: compulsory levy, with no quid pro quo
(3) Assumption that benefits received by an individual is independent of benefits received
by others. This is a fallacy. Experience shows relative superiority confers more
satisfaction than absolute amount of benefit
(4) Does not permit welfare activities to less advantaged members of society. This is
morally foul
(5) Assumes income and wealth are excellent proxy measures of benefits received. This has
been challenged. The law of diminishing marginal utility further diminishes the
argument, for marginal desire for state services decline
(6) Society and individuals that make society are different. Society has its benefits and costs
distinct from individuals. The tax burden of providing for society interest must be
allocated to individuals without reference to any quid pro quo. Similarly activities that
benefit society more than the individual are encouraged while those that injure
society more than the individual are discouraged
(7) Imperfect information may hinder voluntary consumption of benefits. E.g. vaccination
(4) Cost of service theory
- This theory also assumes a contractual relationship between the individual and state stemming
from social contract theory of state.

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- The theory postulates that an individual has no right to services from state outside of the
contract under which the state receives cost of service for services rendered
- This theory recommends
 Scrupulous recovery of cost of service and a balanced budget
 Scrap welfare activities social interests
 Abandon redistributive policies
 Recommends abolition of taxes not related to cost of public goods e.g. windfall
gains, capital gains, gifts, unearned increments, inheritance, expenditure, excise
duty, sales tax and abandon tax reliefs
- Demerits
(1) Difficulty in measurement of cost of services and assigning cost to beneficiaries
(2) Conceptual difficulty in filtering cost to assign to beneficiaries considering efficiency
(3) Should cost be taken as commercial/ private costs or social costs
(4) Who determines the services to render state or the citizens
- This concept can be applied in infrastructure improvement. It can also inform selection of taxes
but it hardly serves as the basis for apportioning tax liability to citizens

(5) Ability to pay

- Does not presuppose a social contract
- Considers taxation in its true form: a compulsory levy by state for which there is no direct and
opposite quid pro quo
- The tax liability of individuals is not related to state activities
- The amount of tax payable by individual is a function of his ability to pay
- The theory is supported by welfare economists and socialists
- Ability to pay theory not only provides social justice but also maximizes social welfare by
minimizing total sacrifice when the principle of equi-marginal sacrifice is followed
- It considers among other variables government expenditure
- Indicators of ability to pay include:
 Income: is the most acclaimed measure of ability to pay but is usually
supplemented by other measures; at least even Adam Smith (1786) made the
assertion.

-income may be divided into two classes: earned and unearned income. The
latter can be subjected to higher taxation without causing negative economic effects. It
is net tax that is taxed not gross.

Limitation

(1) Ability to pay depends pn both income and needs

(2) Ability to pay depends on marginal utility of money income which is
subjective and difficult to measure

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 (3) Its not ea relevant measure of ability to pay for corporate entities
(4) The concept is not easily applicable to consumption expenditure. An
assumption is made that ability to pay can be implied from nature and
quantity of goods and services consumed. This may not hold true.

 Property and wealth: is only relevant where state recognizes right town
property. It provides incentive to persons to work earn , save and invest. If taxed
it provide disincentive to work, save and invest retarding capital accumulation
and economic growth.
-high tax rates may result in decline in wealth leading to serious retardation of
savings, and investment
- is not a good measure of ability and must be taxed with caution at the same
time it’s not advisable to exclude it in measurement of ability to pay
 Consumption expenditure: assumes that people with large consumption
expenditure derive smaller marginal utility from their expenditure therefore
they can pay more tax without losing more utility than those who are spending
less( diminishing marginal utility applied to expenditure)
- It also assumes that income is directly proportional to consumption
expenditure and that consumption expenditure is not desirable as it drains
resources in society hence a legitimate target for taxation
- It’s not a satisfactory measure of ability: it’s difficult to construct and
administer because it’s difficult to determine consumption expenditure over a
year
- use of indirect taxes as a measure such as excise duty, sales tax, VAT
may permit classification of goods and services into different ability classes but
it may also result in regressive taxes
- Taxation of consumption is also criticized as permitting saving and
investment resulting in concentration of wealth and economic power in the
hands of a few capitalists
- Consumption expenditure may therefore be one of the measures of
ability to pay but not the exclusive measure
- It proposes the following forms of taxation based on income as indicator of ability to pay
 Proportional tax
 Progressive tax
 Regressive tax
- Does not recommend balanced budget. it considers independence of government expenditure
to revenues
- This theory may therefore necessitate the use of a battery of proxy measures of ability to pay

In conclusion no one theory is more relevant than others in real life but rather the five theories
provide outer limit of fiscal policy frontiers for state in distribution of tax burden.

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