basicconcepts and purposed of tax

Apt Financial Consultants CPA Reviews, January 2009

P 17: PUBLIC FINANCE AND TAXATION

BASIC CONCEPTS AND PURPOSES OF TAXATION

Taxation is part of public finance. Public finance is that part of economic theory in which deals with the public expenditure (government expenditure for public interest) and public revenue.

Why public finance Government is considered to be responsible to stabilize the economic situation of the

country and Similarly the government plays important role in the economic development process.

Government functions Protective functionsThe government is responsible to maintain peace and security in the country and to defend the country against external aggression. For this purpose, the government maintains Police and Armed forces.

Administrative functionsGovernment is responsible for the administration of the country (i.e. management or direction of affairs of the country). The government establishes various administrative departments for this purpose. e.g. by establishing different ministries.

Social functionsThe government provides social services like education, health, housing etc. These services are vital for the welfare of the society.

Development functionsThe development of different sections of economy is not possible without the state help. For example the government should develop irrigation, transport and communications, industrial and agricultural systems of the country for the rapid increase in the rate of economic growth.

In order to perform these functions effectively and adequately, the government needs funds. Taxation is an important source of the government income and the income of the government from taxes and other sources is known as Public Revenue.

PUBLIC REVENUE.Public revenue means those amounts, which are received by the government from different, sources i.e. income of the government.

The following are the main sources of public revenue. TaxesTaxes may be of different kinds such as

Income tax-a tax which is imposed on the incomes of individuals and businessesCorporation tax-This tax is imposed on profits of limited companiesSales tax—a tax imposed on the sale of commoditiesVAT—This is imposed on the consumption of commodities

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Excise tax—a tax imposed on the production of commoditiesCustom duty—this is imposed on the import or export of commodities

FeesFee is that amount which is received by the government against any direct services rendered by the government e.g. road license fee, import license fee, school/collage fee e.t.c.

Special assessmentsSpecial assessments are those amounts, which are charged for specific purposes. For example, if the government charges a specific amount from the residents of a particular area for the establishment of a secondary school in that area then that is a special assessment.

FinesIf the individuals do not obey the laws of the country then fines may be imposed on such individuals, this comprise the income of the government.

State Property.The forest, mines and National parks are considered as the government property. The income from such departments is also one source of public revenue.

Other sources include foreign aid, etc.

DefinitionsDr. Dalton defined a tax as a “compulsory contribution imposed by a public authority, irrespective of the exact amount of services rendered to the taxpayer in return”

According to Prof. Seligman, “A tax is a compulsory contribution from a person to the government to defray (to pay for) the expenses incurred in the common interest of all, without reference to special benefits conferred”Simon James & Christopher Nobes defined a tax as a compulsory levy by a public authority for which nothing is received directly in return. All these definitions have three common features, first, a tax is not voluntary; it is compulsory for every one on whom it is imposed. Second, only public authority (government) may impose taxes and third, no direct return or special benefit is provided to a taxpayer, i.e it is intended for the common interest of all.

Purposes Of TaxesHowever unpopular taxation may be, governments today are compelled to impose them because of:-

Raising RevenueGovernments need revenue for expenditure on various public services such as the provision of health, education, defence, transport, and many other services.In order to maximize the public interest, the role of government in promoting economic and social development is gaining widespread acceptability and respect particularly where private capital does not necessarily represent the public interest and may even be inadequate to tackle the severe problems of development successfully. Even where

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private capital is coming and adequate, it may not be invested in to the key sectors of the economy because they may not be immediately profitable to the investors who are interested in recovering the capital as quickly as possible.

Fair Distribution of incomeTaxation is increasingly being utilized in the present day, public finance to reduce wide disparities in the distribution of income and wealth between the rich and the poor. Direct taxes are usually used for this purpose, where the rates of tax are progressive i.e. they go on raising as ones income risesHowever, for this to be effective, the funds realized from such taxes must be used for the benefit of the poor, such as through the provision of allowances to the unemployed or housing for the homeless etc

Protection of infant industriesTaxation can also be used to protect the newly established home industries against foreign competition. This can be done by subjecting imported goods to higher customs tariffs (imposing heavy taxes on import of some goods) so that the home made goods can successfully compete with the imported goods since they become cheaper.

Social welfareTaxation is used sometimes, to reduce the consumption of certain commodities, the excessive consumption of which is regarded by the government as being harmful. Taxes on alcoholic drinks, cigarettes etc fall under this category.

Fighting inflationTaxation is also used to withdraw excessive purchasing power out of the hands of the community and so helps to prevent a rise in prices.Simply, inflation may be defined as a situation where by too much money in an economy chases too few goods. By introducing taxes, the government reduces the money available to the public to spend on the few goods and hence help in reducing inflation. However, this is only possible if the government does not end up by spending much itself or else the same situation where too much money chases too few goods will prevail. Rather than spending the money withdrawn from the economyon consumption items, the government has to use it on investments or on what is commonly as government development expenditure.

Basic Efficiency Criteria For Evaluating Taxation Systems (Principles Of an optimal Taxation system)An optimum or good tax system may simply be defined as that tax system which helps to achieve maximum possible number of principles of taxationA good tax system must help to achieve the following:-To maintain economic stabilityBe able to fairly distribute the incomeTo increase the rate of economic growth

When taxes are imposed, certain conditions must be fulfilled so as the tax to achieve the intended objective. These conditions are known as principles of taxation or cannons of taxation.

The common principles of taxation are as follows:-

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The canon of EquityIt states that every person should pay tax according to his ability to pay and not the same amount. It also means that everybody should not pay tax at the same rate.It implies that inequity should be minimized by progressive rates structures. Thus equals should be treated equally (i.e. Horizontal equity) and unequal to be treated unequally (i.e. vertical equity).

The tax system that imposes higher tax rates on the higher income earners than on the lower income earners is termed as a progressive tax system. On the other hand a tax system that attracts higher rates of tax on the lower income earners than on the higher income earners is a regressive one. As well the tax system can be Proportional where the rate of tax is the same regardless of the income of the taxpayer.

The canon of Certainty.The position of any tax should yield the expected revenues in order to assist government’s forward planning. A definitive advance forecast of revenue collections therefore assists implementation and success. Consequently any taxes on commodities whose demand is inelastic (necessities) would be such a sure source of revenue yet governments may not resort to them because of possible adverse social and political implications from those affected. While the tax on business may be fairly uncertain that on employees wages and salaries is fairly easy to pre-determine after allowing for resignations, deaths, fresh supply of labor and promotions’ prospects. The principle of certainty is usually not discussed in relation to the taxpayers’ knowledge of the precise tax payable in any year.

The Canon of SimplicityThe concept of simplicity means that the taxpayers should generally be able to understand the tax system as a whole.The tax base should be easy to identify, taxpayers should be able to calculate and make the tax payments by correct statutory due dates. Another important aspect of simplicity is for taxpayers’ own awareness of the sanctions and penalties provided for any neglect or failure to comply with the tax laws. Unfortunately most tax systems do not satisfy this requirement. A simple tax system is a valuable asset in promoting voluntary compliance.

The canon of EconomyConsideration of what it will cost to collect the taxes is important in any tax system. The administration of the tax system should be least expensive in terms of both manpower and material. Thus, every tax should satisfy the canon of economy in two ways, first, it should be economical for the government to collect it, that is cost of collection should be reasonable compared to revenue collected and second, it should as well be economical to the taxpayer. This means that the taxpayer should be left with sufficient money after paying the tax. A very heavy tax on incomes may discourage saving and investment and adversely affect the productive capacity of the community.

The canon of ConvenienceEvery tax is ought to be levied at the time and in the manner in which it is most likely to be convenient (suitable) for the contributor to pay. The tax system that allows the payment of tax at month end, immediately after the crop harvest season or provides for the payment

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of tax through such devices as PAYE, Value Added tax (VAT) or withholding arrangement can be regarded as convenient to the taxpayers.

In other words, a good tax system:- Should be efficient in that it does not distort economic decision –making

Its administrative and compliance costs should not be excessive

It should not unduly interfere with economic incentives to work, save and invest

It should be considered fair

It should be consistent with macro-economic policy.

Classification/Types of Taxes and their effects.Taxes can be classified as Direct and Indirect taxes. When a person earns an income, he will either consume it all or save part of it. A tax therefore can be imposed on his income, his consumption or savings. When a tax is imposed on income or savings we say the tax is direct e.g corporation tax, estate duty etc and a tax that is imposed on consumption, that is on goods and services, is termed an indirect tax. E.g. customs and excise duties, Value Added tax (VAT), sales tax etc.

Impact and incidence of a taxSimilarly, one can decide whether a tax is direct or indirect by determining its impact and incidence. The impact of a tax is on the person who is first paying the tax or where tax is legally imposed, and the incidence of tax is on the person who finally bears the burden of paying the tax. For example if you pay an income tax monthly, you bear both the impact and the incidence of it; you cannot shift it to any other person.On the other hand, if you go into a shop and purchase an article which includes certain taxes like import duties/value added tax etc. the impact of these taxes and duties is on the importer or trader because in the first instance he pays the tax to the government. The incidence will be on you because you had to pay a price, which includes all those taxes, and, therefore, you are the final one to bear the incidence of those taxes.Thus, a tax is indirect when the impact is on one person and the incident is on another. A direct tax is really paid by the person on whom it is legally imposed, while an indirect tax is imposed on one person but paid partly or wholly by another. An indirect tax is one which can be shifted or passed to another; a direct tax is one which cannot.

Advantages of Direct Taxes

Increase or decrease in direct tax rates does not affect the general price level.

The Low cost of collection; they make collection more efficient especially where taxes are deducted at source such as Pay As You Earn (P.A.Y.E), withholding taxes or when ‘self assessment system’’ is introduced.

They are highly equitable for they are more related to taxpayers’ ability to pay.

Disadvantages of Direct Taxes

They tend to be unpopular as they directly affect the disposable income.

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They are always progressive i.e. they increase as income increases.

In a cash economy like ours and where general level of education of taxpayers is low, it is difficult to detain tax income of taxpayers.

Direct tax laws are difficult to understand as a result they invite disputes and objections every now and then.

Possibility of evading payment, Evasion is encouraged more particularly when rates are high.

Difficult in devising a method that is fair for all classes.

Advantages of Indirect Taxes

As taxes are included in the price of a taxable goods or services a taxpayer does not directly feel the pinch (burden/incidence).

Enables those with small incomes to be reached. I.e. they provide a wide tax base and therefore revenue potential compared to direct taxes.

Difficult of evasion.

Disadvantages of Indirect taxes

Indirect tax is seldom equitable. Taxes on necessities mean lighter burden for the wealthy than the poor who spend a relatively large proportion of their incomes on necessities.

The revenue is not certain, especially when the tax is on luxuries the consumption of which declines in time of depression.

Cost of collection in sometimes heavy, as where customs and excise officials must maintain a careful supervision.

The tax may be shifted to people who were not intended to pay for it.

The tax always cause a rise in price above that actually justified by the tax.

TAXATION SYSTEMSA tax system is made up of tax policy (i.e. that provide the base and guide on which Government may impose tax), tax laws (that give mandate to the government to impose and collect taxes from taxpayers) and tax administration. (for implementation directives and control tax collection – TRA).

There are three systems of taxation namely;

Proportional taxation

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Progressive taxation Regressive taxation

(i) Proportional Taxation

A proportional system is one where the rates of tax are equal so that the same proportion of tax is taken from all incomes, however larger or small. For example, a person with an income of Shs. 200,000 a month, if the rate is 10%, would pay Shs. 20,000 in tax while one with Shs. 300,000 a month would pay Shs. 30,000.

A proportional tax system is not a equitable as progressive tax system because the average rate of tax is constant irrespective of the size of income of the individual in which it is imposed.

(ii) Progressive Taxation

This is a tax system where the rate of taxation increases as the income increases so that the person with an income of Shs. 200,000 a month may pay Shs. 24,000 in income tax, that is 12% of this income whereas a person with an income of Shs. 300,000 may pay Shs. 60,000 that is 20% of the income.

Where great inequality of incomes exists, a progressive system of taxation is regarded as more equitable than proportional system.

(iii) Regressive Taxation

This is a system where the proportion of income taken in tax falls as income rises. It is a tax, the rate of which is higher on people with low incomes than those with high incomes. For example, a tax system is regressive when an individual with an income of shs. 20,000 pays shs.2,000 in taxes (10 percent of income), but an individual earning shs.30,000 pays shs.2,500 (8.3 percent of income).

Some indirect taxes especially those levied on necessities tend to be regressive because consumption of some commodities depends more on the size of family than on incomes.

EFFECT OF TAXATION

The incidence of taxation is the burden which is borne by the taxpayer. If the imposition of particular tax means that a certain person has to pay the full amount of the tax, then the incidence of that tax is upon that person.

In the case of the income tax, the incidence of the tax is upon the receiver of the taxable amount since his income is reduced by the full amount of the tax.

In the case of taxes on commodities the incidence may be upon the buyer or the seller or divided between the buyer and the seller depending on the elasticity of demand of the commodity.

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Generally the demand for necessities is more inelastic than the demand for luxuries. Taxes for necessities usually raise prices more than taxes on luxuries. When the demand for a commodity/product is perfectly elastic, the price does not rise. Thus the incidence of tax is entirely of the seller. If however, demand is perfectly inelastic the incidence will entirely be upon the buyer. In all other cases the incidence will partly fall on the seller and partly on the buyer.

Economic Effects of Taxation

Depending on the economic and social set up of a society other effects of taxation would be as follows:

a. Effect on working ability

If heavy taxes are imposed on necessities of life, affecting the health of workers, therefore the physical ability and efficiency of the people with small incomes will fall and thus affect the total production.

b. Effect on saving abilityLittle saving indicates little investmentTo the individual income earner, the amount to be saved will be reduced by heavy taxes but increasing government investment can offset this.

c. Effect on the desire to work

Many people would feel that it is out worthwhile to work overtime if taxation is heavy. Thus the incentive to work is reduced.

d. Effect on enterprise

Business undertaking depends on profit for their living. Heavy taxes would discourage them from undertaking risks in business they are not sure of succeeding. Taxation checks enterprises but does not consider earning for business failures.

e. Effect of inflation

In order to reduce inflation increased tax could be method but where indirect taxes are increased, the purchasing power of people would be reduced. This act would create a demand for increased wages, thus insuring inflation.

f. Effect on diversion of economic resources

Heavy taxation would shift economic undertaking from heavily taxed ones to lightly taxed occupations, which in most cases will be less productive.

Exercise: 1

1. What are advantages of taxation on income and taxation on expenditure?2. “A tax on profits is ultimately a tax on consumers” Discuss this statement.

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3. What do you mean by “incidence on taxation”4. What are characteristics of a good tax system?5. Relate how taxation may be useful tool for the social and economic development of

Tanzania.6. State the major criteria of an ideal tax system and discuss each of them.7. Discuss the criteria of measuring fairness in taxation.

Tax Rate, Tax Base and Tax yieldThe important distinction between tax rates and tax bases helps us to understand the role of tax expenditures in tax policy. Tax rates are specific levels of tax collection based on given levels of income. On the other hand, tax bases are the portion of income or some other measure such as value of personal property, which is subject to the tax rate. Many combinations of tax rates and tax bases will generate a given level of tax collection; tax collections are also termed a tax yield.

Tax ExpendituresVarious deductions and exclusions may be provided that lower taxable income. Exclusions from taxation comprise the tax expenditures side of a public budget. The term tax expenditure refers to policies that provide tax relief to taxpayers. Tax expenditures are also sometimes referred to as tax references or tax deductions and include all the policies that result into revenue losses for the public treasury. In addition to excluding, exempting, or deducting portions of income from the taxation, tax expenditures also provide preferential rates of taxation, tax credits, and deferred taxation for various economic activities. Thus, tax expenditures are policies that exclude, defer, or exempt portions of income from taxation.

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basicconcepts and purposed of tax

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