Public Finance and Taxation Chapter ThreeJanuary 2022

CHAPTER THREE: INTRODUCTION TO TAXATION

3.1 INTRODUCTION
Government is inconceivable whit out taxation. Tax is the major source of revenue needed to taxes
and a range of tax rates. Excessive tax rate, however, leads to undesirable economic effects it induces
taxpayers to change their behavior to avoid or lessen tax liabilities. In this concoction, any tax tends
to discourage saving, investment and work. Apart from raising the necessary revenue, taxes have
multiple objectives. Thus, tax policies have to be designed properly in order to promote incentives to
work, save invest and support economic growth and equity. Tax reform, therefore has to balance
multiple objectives of taxation including, raising adequate revenue, ensuring economic efficiency
and equity. It must limit unproductive taxes and tax incentives, keep differentia rates to a minimum
and reduce economic distortions. In the past the government attempted to reduce the excessively
high tax rates, in order to reduce distortion and encourage compliance.
3.2 NATURE OF TAX
A “tax” is a compulsory levy and those who are taxed have to pay the sums irrespective of any
corresponding return of services or goods by the government. The tax, pays do get many benefits
form the government but no tax-payer has a right to any benefit from the public expenditure on the
ground that he is paying a tax. The benefits of public expenditure may go to anyone irrespective of
the taxes paid.
A tax is a liability imposed upon the tax assessed who may be individuals, groups of individuals, or
other legal entities. It is a liability to pay an amount on account of the fact that the tax assesses have
income of the minimize amount and form certain specified resources, or that they own certain
tangible or intangible properly or that they easily on certain economic securities which have been
chosen for taxation. Thus a tax is generalized exaction it may be noted that a public receipt
containing an element of compulsion does not automatically become a tax. Public authorities charge
prices for specific service or goods supplied by them. Here the individuals and firms etc pay
voluntarily, for the purchase of these goods and services but the element of compulsion is not always
missing. If the authorities have a monopoly of the good or service in question (such as the city bus
service) and if they choose to charge a price in excess of the competitive one (that is the cost of
production inclusive of a normal, profit), then the ‘excess’ price paid becomes a tax for the buyers.
We must however remember that it is not easy to separate the elements of pure price and taxation is
such situations and the problem becomes more complicated when the public undertaking have a high
costs of production on grounds of inefficiency. Again, there may be some goods or services

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regarding which the ‘consumers’ have no choice the authorities may thrust the supplies on them
compulsorily and collectively even when all the members of the society do not want them.

3.3 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. 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 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 650 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.
(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.
(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. The government compulsorily collects all types of taxes and does not
give any direct benefit to tax-payers for taxes paid. For example, when taxable income is earned
by an individual or a corporation, he or it simply pays the tax amount at the specified rate cannot
demand any benefit against such payment.
(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. 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.

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(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. In any case, he
would want his share to be within the general level of tax burden being borne by others. In other
words, it is essential that a good tax system should appear equitable to the tax-payers. Similarly,
overall burden of the tax system is of equal importance. The attitudes of the tax-payers in this
regard are influenced by a host of other factors like the political situation such as war or peace,
natural calamities like floods and droughts, economic situations like prosperity or depression and
so on.
(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.
(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. 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
3.4 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.
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. 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.
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.

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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
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.
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.
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.
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
(10) Enhancement of standard of living: The government also increases the living standard of people
by giving tax concessions to certain essential goods.

3.5 CLASSIFICATION OF TAX

3.5.1 Direct and Indirect Taxes:

Taxes are sometimes referred to as direct or indirect. The meaning of these terms can vary in
different contexts, which can sometimes lead to confusion. In economics, direct taxes refer to those
taxes that are paid by the person who earns the income. By contrast, the cost of indirect taxes is
borne by someone other than the person responsible for paying them. For example, taxes on goods

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are often included in the price of the items, so even though the seller sends the payments to the
government, the buyer is the real payer. Indirect taxes are sometimes described as hidden taxes
because the purchaser of goods or services may not be aware that a proportion of the price is going to
the government.
 Direct Taxes: 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. 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.
 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. The person who is required to pay the tax does not bear its
burden. Thus, indirect taxes can be shifted.
Impact, incidence and Shifting
 Impact: The impact of a tax is on the person who pays the tax in first instance. In other words,
the person who pays the tax to the government in the first instance bears its impact.
Therefore, the impact of a tax is the immediate result of the imposition of a tax on the person
who pays it in the first instance. It refers to the immediate burden of the tax and not to the
ultimate burden of the tax.
 Incidence: Incidence of a tax means the final or ultimate resting place of the burden of the
tax payment. It refers to the point at which "tax chickens finally come to the roost ". the
ultimate burden of the tax
 Shifting : It refers to the process by which the money burden of a tax is transferred from one
person to another
Advantages of Direct Taxes
1. Ensures the principle of ability to pay: Direct taxes are based on the principle of ability to
pay. They fall more heavily on the rich than on the poor. The tax burden is distributed on
different sections of the society in a just and equitable manner.

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2. Reduces the social and economic inequalities: Direct taxes reduce a discrepancy in the
distribution of income and wealth. By adopting the progressive tax system, rich people will
pay on higher rates of taxation, while the poor pay on lower rates or gives exemptions
3. Certainty: Direct taxes satisfy the canon of certainty. The time of payment, mode of payment,
the amount to be paid etc. are made clear for direct taxes. Both the taxpayers and the
government know the amounts to be paid and the government can estimate the revenue from
these taxes.
4. Economy: The cost of collection of direct taxes is low because the government adopts the
different methods of collections like tax deductions at source, advance payment of tax etc.
Besides, the taxpayers pay the amount of tax directly to government. Thus, the principle of
economy is achieved in the case of direct taxes.
5. Elasticity: Direct taxes are elastic in nature. For example, when the income of the people
increases, the tax revenue also increases. Moreover, during the unforeseen situation like flood, war
etc. the government can raise its revenue by increasing the tax rates without affecting the poor.
6. Educative Effect: Direct taxes create civic consciousness among taxpayers. Since the taxpayers
feel the burden of tax directly, they are interested in seeing that the government properly spends
the money. They are conscious of their rights and responsibilities as a citizen of the state.
7. Control the effects of trade cycles: Direct taxes control the effects of trade cycles. They can be
used as a tool to mitigate the effects of inflationary and deflationary trends by raising or reducing
the tax rates.
Limitations of direct taxes

1. Arbitrary in Nature: Direct taxes tend to be arbitrary because of the difficulty in measuring
the ability to pay tax. Paying capacity of the people cannot be measured precisely.
2. Inconvenience: Under direct taxes, the taxpayer has to adhere to many legal formalities such
as submission of the income returns, disclosing the sources of income etc. Moreover, he/she
has to follow numerous accounting procedures which are difficult to comply with.
3. Possibility of tax evasion: The high rates of direct taxes create the tendency to evade more.
There is possibility for tax evasion by fraudulent activities. Thus, the direct taxes are the taxes
on honesty.
4. Limited scope: The scope of the direct tax is very limited. In Ethiopia, most of the people
come under or below the middle-income category. If only direct tax is followed, these people
cannot be brought into the tax net (system) because of the basic exemption given. Thus, the
government cannot depend upon direct tax alone.

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5. Disincentive to work, save, and invest: When the taxpayer earns certain level, they have to
pay more, because of the higher rate of taxes attributed to the higher lumps. This will in turn
discourages them to work further, save and invest
6. Expensive to collect: Under direct taxes, each and every taxpayer is separately assessed.
Thus, the large number of taxpayers to be contacted and assessed and the prevention of tax
evasion make the cost of collection more expensive
Merits of indirect taxes
A. Convenience: Indirect taxes are more convenient to the taxpayers. Since the tax is included
in the selling price of the commodities, the consumer pays the tax when he/she purchases
them. He/she pays the tax in small amounts (installments) and does not feel its burden.
B. Wide Scope: While the people with income and wealth above a certain limit, are brought
under the levy of direct taxes, indirect taxes are paid by all both poor and rich.
C. Elastic: The revenue from the indirect taxes can be increased. Whenever the government
wants to raise its revenue, or lower it, it can be achieved by increasing and decreasing the
rates of taxes on the commodities whose demand is inelastic
D. Tax evasion is not possible: Indirect taxes are included in the selling price of the
commodities. So, evading of such tax becomes very difficult
E. Substantial revenue: Indirect taxes yield substantial revenue to both central and state
governments. The developing countries like Ethiopia are heavily dependent on indirect taxes
F. Discourages the Consumption of Articles Injurious to Health: Indirect taxes discourage
the consumption of certain commodities, which are harmful to health. By imposing very high
rates of taxes on commodities like liquors, drugs, cigarettes etc., which are harmful to health,
their consumption can be reduced.
Limitations of Indirect Taxes
A. Ability to pay principle is violated: Indirect taxes are not directly connected to the
taxpayers' ability to pay. Therefore, both the rich and poor equally pay the tax. Thus, the
principle of ability to pay is violated. Indirect taxes are regressive in nature.
B. Uncertainty: If indirect taxes are not levied on the commodities of common consumption
and levied only on luxurious articles, they tend to be inelastic. The quantity demanded will be
affected by the imposition of the taxes. Thus, the revenue generated from them is uncertain.
C. Discourages Saving: Indirect taxes are included in the selling price of the commodities.
Hence, the people have to spend more on the purchase of the goods. This, in turn affects the
savings of the people

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D. Civic Consciousness is Not Created: Under indirect taxes, taxpayers don’t feel the burden
of the tax. They are not aware of their contribution to the State. Thus, indirect taxes do not
create the civic consciousness in the minds of the people.
Differences between Direct and Indirect Taxes
1. Shift ability 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. 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. For example,
now people having income above Birr.650, 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. 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 . 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. Moreover, the taxpayers need not follow any legal formalities in the
payment of tax. Thus, indirect taxes are more convenient to them.
6. Civic Consciousness: People felt the burden of direct taxes directly. The taxpayer is conscious of
his contribution to the Government and interested in knowing whether the tax paid by him is
properly used or not. In this way, it creates civic consciousness among the taxpayers. But indirect
taxes do not raise such consciousness among the taxpayers, because they pay the taxes indirectly.

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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.
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.
9. Examples: The examples for direct taxes are income tax, wealth tax, gift tax, estate duty etc. The
examples for indirect taxes are customs duty, excise duty, sales tax, and service tax etc.

Single Vs Multiple Tax System

 On the basis of volume (Single and Multiple tax)
Single tax: - It refers to the system in which the taxes are levied only on the ‘item’ or ‘head of tax’.
There is only one kind of tax, which constitutes the source of public revenue.
Multiple taxes: - It refers to the system in which the taxes are levied on various items.

Tax structure
Proportional, Progressive, Regressive and digressive
8. Proportional taxes: - A system that taxes everyone at the same rate, regardless of his or her
income brackets. It is amount increase with the increase in income and decreases with the
decrease in income.
Merits of proportional tax system
 It is simple in nature.
 It is uniformly applicable
 Proportional taxation leaves the relative economic status of taxpayers unchanged
 It will avoid mistakes and drawbacks of progressive tax system
Limitations of proportional tax system
 Inequitable distribution: A system of proportional taxation would not lead to an equitable
and fair direction of the burden of taxation. This is because it falls more heavily on the small
incomes than on the high incomes
 Inadequate resources: The system of proportional taxation means that the tax rates for the
rich and poor are the same. Hence, the government cannot obtain from the richer sections of
the society as much as they can give.
 Inelastic in nature: Proportional tax system is inelastic in nature, because the government
cannot raise the rate whenever it wants to raise the revenue.

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9. Progressive taxes: - It is the tax which varies with the change in income of the different
individuals.
The rate of tax is gradually higher for the increasing incomes and lower for the decreasing incomes.
Merits of progressive tax system
 Equality in Sacrifice: Under progressive tax system, the rate of taxation increases as the tax
base increases. This means the burden of taxation is heavy upon the rich than on the poor.
Thus, this system secures equality in sacrifice by ensuring the principle of ability to pay.
 Reducing the inequalities of income and wealth: Progressive tax system serves as a
powerful instrument for reducing the inequalities of income and wealth.
 Economy: In the progressive system, the cost of collection does not increase with the
increase in the rate of taxes. Hence, it is justified on the grounds of economy
 Elastic: The government can easily raise its revenue by increasing the rates of taxes. In the
case of progressive taxation, raising the rates for the higher status alone can raise more
revenue
 Stabilizing the economy: Progressive tax system may be helpful in preventing the
inflationary trends in the economy as it reduces the disposable income and purchasing power
of the people.
Limitations of progressive tax system

 Disincentive to Work: It is argued that too progressive tax rate acts as a disincentive to
work.
 Discourages savings and investments: Very high rates of progressive taxes used to
discourage savings and investments. Since a major portion of the income is taken away by the
way of taxes, the incentives to produce more and earn more are lost.
10. Regressive tax structure: - Under it, the larger the income of tax-payer, the smaller is the
proportion that he contributes. A schedule of regressive tax rate is one in which the rate of
taxation decreases as the base increases.

11. Digressive tax structure: in this type of tax structure, the tax rate will progressive up to a
certain level of income of the taxpayers and then become constant after the maximum level of
their income range. Digressive tax is a mix between the progressive and proportional tax
systems. In the case of digressive tax, the tax rate is increased firstly with increase in income
and then, the rate remains flat or constant with further increase in income

3.6 PRINCIPLES OF TAXATION

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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. Mostly,
however, objectives of taxation conflict with each other and a compromise is needed. Therefore,
usually economists select some important objectives and work out the corresponding principles
which the tax system should adhere to. The first set of such principles was enunciated by Adam
smith (which he called Cannons of Taxation)
Canons of Taxation
The four canons of taxation as prescribed by Adam Smith are the following:
(1) Canon of Equality (ability to pay principles): This canon proclaims that a good tax is that which
is based on the principle of equality. In other words subjects of every state ought to contribute
towards the support of the government, as nearly as possible, in proportion of their respective
abilities, that is, in proportion to the reserve which they respectively enjoy under the protection of
the State. It implies what the income which a person enjoys under the protection of the State,
should be taxed on the proportional rate of taxation. But modern economists do not agree with
Adam Smith. They advocate progressive taxation to observe the canon of equality. In other
words, they advocate progression should be the basis for imposing taxes. Ability is the "ideal ethical
basis of taxation
i) Horizontal Equity
Horizontal equity is said to be achieved if persons in the like circumstances are taxed to the same
extent. That means, equals should be treated equally and unequal should not be treated equally in the
process of taxation.

ii) Vertical Equity

According this principle people with greater ability to pay should pay more in taxes than those
with lower ability to pay. This implies that individual with higher income should pay more
than the one with less income.
(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. According to 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.” Adam Smith was also of the view that the government must also be

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certain of the amount which it derives from a particular tax. Thus this canon is equally important
both for individual and the state.
(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.
(4) Canon of Economy: 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 because levying of a tax may require a great number of officers,
whose salaries may eat up the greater part of the produce of the tax, and whose pre-requisites
may impose another additional tax upon the people. Hence, the administrative cost should be
minimum.
In addition to the above four canons given by Adam smith, the following other canons have been
advanced by Bastable and other economists
(5) Canon of Productivity: 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.
(6) 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.
(7) Canon of Diversity: 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.
(8) 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

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are able to guess easily the aim of its imposition and they are not confronted with accounting,
administrative or any other difficulties.
(9) Canon of Expediency: 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.
3.7 Tax Evasion and Tax Avoidance

3.7.1 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”.
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.
There are two forms of tax evasion. They are as follows:
1. Suppression of income, and
2. Inflation of expenditure.
Examples for Tax Evasion: The following are the examples for tax evasion:
1. A trader makes a sale for Birr.20, 000 and does not account it, in his books under sales. He is
evading tax.
2. An individual lends his money of Birr.50, 000 to another person at 20% interest per annum and
does not include this income in his total income.
3. Under-invoicing of sales and inflation of purchases.
4. A manufacturing business employs 30 workers but include 2 more additional namesake workers
(not in actual) in the muster roles. The sum shown as paid to such additional namesake workers will
amount to evasion.
Human intelligence devices new methods of evasion and the Governments are constantly trying to
remove the loopholes in the tax laws.

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3.7.1.1 Causes of Tax Evasion

 High rates of taxation; - Prevalence of high tax rates is the first and foremost reason.
 Complexity of tax laws; - Complicated tax laws are another reason for tax evasion. The tax laws
contain a number of exemptions, deductions, rebates, relief, surcharges and so on. So, such
complication in tax-laws is also a root-cause for the tax evasion.
 Inadequate Information as to Sources of Tax Revenue:-Lack of adequate information as to the
sources of revenue also contributes to tax evasions. In Ethiopia, small businessmen and farmers
rarely maintain any accounts of their income.
 Lack of publicity;-Lack of publicity of information of a person’s return or assessment, is yet
another reasons for tax evasion.
 Moral and Psychological factors; - moral and psychological factors have also been pointed out
as responsible for tax evasion.
 Every person should realize his responsibility towards the govt.
 Unfortunately, all citizens do not realize their duties to the govt. and the necessity of
paying the correct amount of taxes and paying them in time.
 officers of the department should be men of integrity;- Lack of integrity in some of the officers
of the department is also responsible for tax evasion
3.7.1.2 Methods/Sources of Tax Evasion
 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.
 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.
 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.

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 Tax evaders have been opening number of bank accounts under dummy names.
 Deduction of personal expenses as business expense.
 Some employees of big business houses regularly deduct their personal expenses from office.
 For example, an officer using official transportation for personal purposes.
 By treating personal expenses as business expenses, people increase business expenses thus
lowering the profit of the enterprise.
 Omission to report several incomes from irregular sources.
 Many individuals are in receipt of different types of income from different irregular sources.
 For example, people receive interest on deposits in the banks or dividend on shares.
 But they rarely report such income to the taxation authorities.
 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.
 Hence, he takes such steps as to underestimate his receipts so that he could reduce his tax
liability.
 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.
3.7.2 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.
 But whatever be the method an assessed 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.
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.

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