School of Business and Management

Bachelor of Accounting
ACC717 - Taxation

Topic 1: - Taxation Principles

Prepared John Awakari

What is taxation
• Taxation is the process by which the government
collects money from people to use for government
purposes. When the government charges a tax on
income earned, products purchased, and property
owned, this is an example of taxation.
• Government uses such tax to finance its expenditures.
• Government charges tax to its citizens on equitable
bases over the year.
Five maxims of Taxation
1. Simplicity
2. Equity
3. Certainty
4. Economy
5. Convenience
Simplicity
• Tax system should be simple for tax payers to understand.
Few people complain about sales taxes, for example. Sales
tax is easy - if you purchase something, you pay a percentage
of its price to the state or local government as a tax. In
Europe, a national tax known as a value-added tax, or VAT, is
in essence a sales tax. In the United States, campaigners for a
more simplistic tax code often campaign for a flat tax, in
which a flat percentage would be charged on all incomes.
With the current system, billions are spent every year to file
taxes. People who argue for a simpler tax code see these
billions as dollars that could be better spent elsewhere.
Equity (fairness)
• The first principle of a good tax system emphasised by Adam
Smith is of equality. According to the canon of equality, every
person should pay to the Government according to his ability to
pay, that is, in proportion of the income or revenue he or she
earned.

• Thus under the tax system based on equality principle the richer
persons in the society will pay more than the poor.

• Taxes should be proportional to income, that is, everybody

should pay the same rate or percentage of his income as tax.
Equity (cont…)
• However, modem economists interpret equality or
ability to pay differently from Adam Smith. Based on
the assumption of diminishing marginal utility of
money income, they argue that ability to pay principle
calls for progressive income tax, that is, the rate of tax
increases as income rises. Now, in most of the
countries, progressive system of income and other
direct taxes have been adopted to ensure equality in
the tax system.
Horizontal equity
• Those who are equal, that is, similarly situated
persons ought to be treated equally. This implies that
those who have same income should pay the same
amount of tax and there should be no discrimination
between them.
Vertical Equity
• The concept of vertical equity is concerned with how
people with different abilities to pay, should be
treated for the purposes of division of tax burden. In
other words, what various tax rates should be levied
on people with different levels of income, A good tax
system must be such that it can ensure the horizontal
as well as vertical equity.
Certainty
• Adam Smith, ‘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 clear and plain to
the contributor and to every other person. A
successful function of an economy requires that the
people, especially business class, must be certain
about the sum of tax that they have to pay on their
income from work or investment.
Certainty (cont…..)
• lack of certainty in the tax system, encourages
corruption in the tax administration. Therefore
in a good tax system, “individuals should be
secure against unpredictable taxes levied on
their wages or other incomes; the law should be
clear and specific; tax collectors should have
little discretion about how much to assess tax
payers; for this is a very great power and subject
to abuse.
Convenience
• The sum, time and/manner of payment of a tax
should not only be certain but the time and manner
of its payment should also be convenient to the
contributor. If land revenue is collected at the time of
harvest, it will be convenient since at this time
farmers reap their crop and obtain income.
• Tax is levied on the basis of income received rather
than income accrued during a year. This makes tax
system convenient.
Economy
• The Government has to spend money on collecting
taxes levied by it- Since collection costs of taxes add
nothing to the national product, they should be
minimized as far as possible. If the collection costs of
a tax are more than the total revenue yielded by it, it
is not worthwhile to levy it.
• Tax system should be simple as possible and tax laws
should not be subject to different interpretations.
Flexibility
• It should be possible to change the tax if economic
activity changes or government aims change. The
revenue from some taxes changes automatically to
offset economic booms and slumps. For instance, tax
revenue rises from income tax and sales tax, without
any change in the rates, when there is an economic
boom. This is because more people will be employed,
incomes will rise and people will spend more. Such a
rise in tax revenue may slow down the rise in
aggregate demand and prevent inflationary pressure
building up.
Tax Rates
• Progressive
• Proportional
• Regressive
Progressive tax rate
• A tax in which the tax rate increases as the taxable amount
increases. The term "progressive" refers to the way the tax rate
progresses from low to high, with the result that a taxpayer's
average tax rate is less than the person's marginal tax rate.

Rate

Tax base.
Proportional tax rate
• A tax imposed so that the tax rate is fixed, with no change as the
taxable base amount increases or decreases. The amount of the tax
is in proportion to the amount subject to taxation. ... As a result,
such a flat marginal rate is consistent with a progressive average tax
rate.

Rate

Tax base
Regressive tax rate
• The more income you earn the less tax you pay.
Regressive tax rate (cont….)
• Taxes are regressive when they impose a harsher
burden on the poor than the rich. In poor families, a
larger proportion of their income pays for shelter,
food, and transportation. Any tax decreases their
ability to afford these basics. The wealthy, on the
other hand, can afford the basics. Taxes decrease
their ..
Tax Base
• Tax base is defined as the income or asset balance used to calculate a tax
liability, and the tax liability formula is tax base multiplied by tax rate. The rate
of tax imposed varies depending on the type of tax and the tax base total.
• Base = B
• Tax = T
• Rate = R

Tax amount = B x R

Rate = T/B = Average tax

As tax base increases, the tax rate also increases.

Tax Base (cont….)
• The choice of a personal income tax consists of the choice of
a tax base and then the choice of a tax rate schedule. The
ideal tax base is the earnings ability (wage rate) of each
individual, since this is the only characteristic that is assumed
to dier across people.
• In practice, however, earnings ability cannot be monitored
for tax purposes. The earnings ability is labor income (wage
rate times hours of work), so that the labor income is the
natural choice of a tax base and then derived the optimal
rate schedule given this tax base.
Criteria for selecting the tax base.
• Equity or fairness,
• Taxes could be set based on people's ability to pay
them. Or taxes could be set based on the
government services or benefits people receive.
Ability to pay principle
• Under the ability to pay standard taxes are set based on
measures of a taxpayer's income or wealth. Income is the most
common measure of ability to pay. Taxes are labeled progressive
when they are an increasing proportion of income as income
rises. The Solomon Islands income tax rate structure is
progressive, since those with higher incomes are taxed at higher
rates. Taxes are labeled regressive when they are a decreasing
proportion of income as income rises. The social security tax is
regressive, because taxes are not collected on income above a
certain limit. Taxes are labeled proportional when they are a
constant proportion of income as income rises. A flat rate tax
without deductions or exemptions would be proportional. Other
measures of ability to pay could be wealth or net worth.
Service received or benefit principle.
• Under the services received or benefit principle, taxes
are set based on the government services taxpayers
consume or the government facilities they use. A
gasoline tax with proceeds devoted to road
maintenance is perhaps the tax closest to the benefit
standard. Roughly speaking, those who use the roads
pay for their repair. Some benefit taxes might more
accurately be called fees or charges. An admission fee
at a public park is an example.
Impact of taxation and the economic
efficiency.
• The most important objective of taxation is to raise required
revenues to meet expendi­tures. Apart from raising revenue,
taxes are considered as instruments of control and regulation
with the aim of influencing the pattern of consumption,
production and distribution. Taxes thus affect an economy in
various ways, although the effects of taxes may not
necessarily be good. There are same bad effects of taxes too.
Effects of Taxation on Production
i. effects on the ability to work, save and invest,
ii. effects on the will to work, save and invest,
Effects on the ability to work, save and
invest
• Imposition of taxes results in the reduction of
disposable income of the taxpayers. This will reduce
their expenditure on necessaries which are required
to be consumed for the sake of improving efficiency.
As efficiency suffers ability to work declines. This
ultimately adversely affects savings and investment.
However, this happens in the case of poor persons.
Effects on the ability to work, save and
invest
• Taxation on rich persons has the least effect on the efficiency and
ability to work. Not all taxes, however, have adverse effects on the
ability to work. There are some harmful goods, such as cigarettes,
whose consumption has to be reduced to increase ability to work. That
is why high rate of taxes are often imposed on such harmful goods to
curb their consumption.
• But all taxes adversely affect ability to save. Since rich people save
more than the poor, progressive rate of taxation reduces savings
potentiality. This means low level of investment. Lower rate of
investment has a dampening effect on economic growth of a country.
• Thus, on the whole, taxes have the disincentive effect on the ability to
work, save and invest.
Effects on the will to Work, Save and
Invest
• The effects of taxation on the willingness to work, save
and invest are partly the result of money burden of tax
and partly the result of psychological burden of tax.
• Taxpayers have a feeling that every tax is a burden. This
psychological state of mind of the taxpayers has a
disincentive effect on the willingness to work. They feel
that it is not worth taking extra responsibility or putting in
more hours because so much of their extra income would
be taken away by the government in the form of taxes.
Thankyou