The Theory of Taxation and Tax Policy Notes

Public Revenue and Definitions of Taxation

• Total Public Revenue: This refers to the total resources mobilized by a government within a given fiscal year to finance its various activities.
• Taxation: Recognized as the most substantial item on the revenue side of public budgets.
• User Charges: These are prices charged for the delivery of specific public goods and services.     * Examples include public health service utilization charges, toll roads, and charges at public parks.
• Commercial Activities: Revenue generated from state-owned enterprises (SOEs) and public corporations.     * Examples include Telecommunication services, the Ethiopian Electric Power Authority (ELPA), and Ethiopian Airlines (EAL).
• Administrative Fees: Charges levied for regulatory and administrative services.     * Examples include license fees and stamp duties.
• Divestment and Sale of Government Assets: Revenue from the sale of state property.     * Examples include the sale of used trucks or Tele shares.
• Borrowing and Grants: Capital revenues obtained from both domestic and foreign sources.     * Examples include government bonds, international aid, and concessional loans. Concessional loans are characterized by low interest rates and flexible repayment schedules.

Federal Government Actual Revenues (2005–2008 EC)

• Total Actual Revenue (Billions Birr):     * 2012: $130.7$     * 2013: $147.1$     * 2014: $166.4$     * 2015: $206.2$
• Items of Domestic Revenue (Billions Birr):     * 2012: $90.7$     * 2013: $103.5$     * 2014: $129.8$     * 2015: $147.7$
• Detailed Tax Revenue Components (Billions Birr):     * Tax on Income and Profit: $19.4$ (2012), $25.5$ (2013), $31.0$ (2014), $35.7$ (2015).     * Domestic Indirect Taxes: $19.2$ (2012), $23.9$ (2013), $26.8$ (2014), $30.2$ (2015).     * Value Added Tax (VAT): $16.4$ (2012), $19.5$ (2013), $21.9$ (2014), $24.8$ (2015).     * Stamp Sales and Duty: $0.4$ (2012), $0.5$ (2013), $0.6$ (2014), $0.7$ (2015).     * Tax On Foreign Trade: $36.8$ (2012), $44.0$ (2013), $50.5$ (2014), $60.9$ (2015).
• Non-Tax Revenue (Billions Birr):     * 2012: $13.5$     * 2013: $9.9$     * 2014: $20.8$     * 2015: $20.0$
• External Assistance and Loans (Billions Birr):     * External Assistance: $20.4$ (2012), $23.1$ (2013), $15.8$ (2014), $28.5$ (2015).     * External Loan: $19.5$ (2012), $20.4$ (2013), $20.9$ (2014), $30.0$ (2015).

Percentage Share of Federal Government Revenue Sources (2005–2008 EC)

• Domestic Revenue Share (%):     * 2005: $69.41$     * 2006: $70.38$     * 2007: $77.96$     * 2008: $71.64$
• Tax Revenue Share (%):     * 2005: $58.07$     * 2006: $63.48$     * 2007: $65.07$     * 2008: $61.49$
• Income and Profit Tax Share (%): Peak at $18.63\%$ in 2007; trough at $14.87\%$ in 2005.
• VAT Share (%): Ranges between $12.02\%$ (2008) and $13.28\%$ (2006).
• Foreign Trade Tax Share (%): Constant around $28\%$ to $30\%$.
• External Assistance Share (%): Highest in 2006 ($15.74\%$) and lowest in 2007 ($9.49\%$).
• External Loan Share (%): Ranges from $12.56\%$ (2007) to $14.95\%$ (2005).

Fundamental Concepts and Key Characteristics of Taxation

• Definition of Tax: A compulsory contribution levied by the government to finance common expenses for a collective purpose.
• Taxation: The specific process of raising government revenue via the imposition of taxes.
• Key Characteristics:     1. It is a compulsory payment.     2. No direct service or benefit is expected in return for the specific payment made.
• Legal Implications: Failure to pay taxes is punishable by law.
• Collection Schedule: Taxes may be collected regularly (annually or monthly) or occasionally, based on tax legislation conditions.

Purposes of Taxation

• Revenue Generation: Raising funds to provide and allocate public goods and services.
• Correcting Externalities: Utilizing corrective taxes to address negative externalities, such as industrial pollution.
• Regulating Market Power: Limiting the influence of monopolies to promote fair market competition.
• Income Redistribution: Aiming to reduce inequality by shifting income from the wealthy to the poor.
• Macroeconomic Stabilization: Managing inflation and unemployment to support economic stability.
• Discouraging Harmful Consumption: Reducing the use of socially undesirable goods like alcohol and cigarettes through high taxes.
• Protecting Domestic Industries: Using tariffs and protective taxes to shield local businesses from foreign competition.
• Preventing Dumping: Imposing higher taxes to discourage the dumping of imported goods.
• Correcting Balance of Payments: Taxing imports heavily and providing tax incentives for exports to improve trade balances.

Major Types of Taxes in Ethiopia

• Income Tax:     * Payroll Tax: Structured as a progressive tax ranging from $0\%$ to $35\%$.     * Business Owners Tax: Proportional rate of $30\%$.     * Coverage: Individuals, businesses, and organizations; applies to salaries, wages, and annual profits.
• Value Added Tax (VAT):     * Rate: $15\%$.     * Coverage: Businesses with an annual turnover exceeding $ETB\,1,000,000$.     * Application: All goods and services excluding exemptions like medicine.
• Turnover Tax (ToT):     * Rate: $2\%$ on local goods/services; $10\%$ on specific services like garages.     * Coverage: Non-VAT businesses with annual turnover below $ETB\,1,000,000$.
• Corporation Tax:     * Rate: $30\%$.     * Coverage: Profits earned by share companies and incorporated businesses (e.g., MIDROC).
• Excise Duty:     * Rate: $10\%$ to $100\%$ depending on the product.     * Coverage: Selected locally produced or imported goods such as cigarettes, alcohol, and used cars.
• Withholding Tax:     * Rate: $2\%$ or $3\%$ of gross payment.     * Coverage: Organizations with legal personality (NGOs, government agencies) on employee wages and service contracts.
• Custom Duty: Rates vary by commodity; applied to the import and export of goods like electronics or coffee.
• Road Fund Tax: A fixed levy on car owners for road maintenance.
• Airport Tax: A fixed levy on passengers and cargo transported by aircraft.
• Stamp Duty: Variable rates assigned to the transfer of property (land, houses) and legal documents (shares).

Tax Incidence: Statutory vs. Economic

• Statutory Incidence (Impact): Refers to the party that is legally responsible for paying the tax burden under the law.
• Economic Incidence: Refers to the party that ultimately bears the cost of the tax after market adjustments (changes in prices, profits, or wages).
• Tax Shifting: Occurs when statutory and economic incidence differ. The burden is shifted wholly or partially to another party.     * Example: A sales tax imposed on sellers is passed to consumers through higher retail prices.

Classification of Taxes

• By Impact (Direct vs. Indirect):     * Direct Taxes: Levied directly on income/wealth. Statutory and economic incidence fall on the same person/company. Examples: personal income tax, rental income tax. Usually progressive.     * Indirect Taxes: Levied on goods/services and collected by intermediaries (sellers). Incidence is shifted to consumers. Examples: VAT, excise duties. Usually regressive.
• By Tax Base:     * Income Tax: Levied on individual or company profits.     * Capital/Property Tax: Levied on tangible or intangible wealth/assets (e.g., Capital Gains Tax).     * Consumption Tax: Levied on purchases (VAT, Customs).
• By Tax Rate:     * Progressive Tax: Rate increases as the tax base rises. Ethiopia's income tax ($0\text{-}35\%$ for income above $14,000\,Birr$) is progressive.     * Proportional Tax: Rate remains constant regardless of the base. Wealthier individuals pay more in absolute terms, but the percentage is fixed (e.g., a $10\%$ flat tax).     * Regressive Tax: Takes a smaller proportion of income as the base increases.         * Example (VAT): If Mr. X earns $200,000\,Birr$ and Mr. Y earns $150,000\,Birr$, both pay $7,500\,Birr$ VAT for a TV. Mr. X pays $3.75\%$ of income while Mr. Y pays $5\%$. This demonstrates the regressive nature because the relative burden is higher for lower-income earners.

Analysis of Tax Incidence in Competitive Markets

• Partial Equilibrium Analysis: Focuses on a producer legally liable to pay a per-unit tax in a perfectly competitive market.
• Market Adjustments:     * Imposition of tax shifts the supply curve upward from $S_0$ to $S_1$.     * Output reduces from $q_0$ to $q_1$.     * Price increases from $p_0$ to $p_c$.
• Tax Burden Distribution:     * Total Tax per unit: Distance $AC$ or $p_c - p_s$.     * Paid by Producer: $p_0 - p_s$.     * Paid by Consumer: $p_c - p_0$.     * Total Revenue: Rectangle $p_s p_c A C$.     * Deadweight Loss (DWL): Triangle $ABC$.     * Consumer Surplus Reduction: $p_c A D p_0$.     * Producer Surplus Reduction: $p_s p_0 D C$.
• Elasticity Rule: The distribution of the burden depends on the elasticity of supply and demand.     * If supply is more elastic ($\epsilon_s > \epsilon_d$), consumers share more of the burden; if demand is more elastic ($\epsilon_d > \epsilon_s$), producers share more of the burden.

Mathematical Derivation of Tax Incidence

• Setup: Let $p_d$ be the price paid by consumers and $p_s$ be the price received by producers.
• Equation (1): $t = p_d - p_s$
• Equation (2): $dt = dp_d - dp_s$
• Equation (3): $dp_s = dp_d - dt$
• Derived Changes in Equilibrium:     * $dQ_d = D_p dp_d$     * $dQ_s = S_p dp_s = S_p(dp_d - dt)$     * At equilibrium: $dQ_d = dQ_s \rightarrow D_p dp_d = S_p(dp_d - dt)$
• Tax Burden on Consumer:     * $\frac{dp_d}{dt} = \frac{S_p}{S_p - D_p}$     * Expressed in elasticity: $\frac{dp_d}{dt} = \frac{\epsilon_s}{\epsilon_s - \epsilon_d}$
• Limiting Cases:     1. If $\epsilon_d = 0$, $\frac{dp_d}{dt} = 1$ (Whole burden on consumer).     2. If $\epsilon_d = \infty$, $\frac{dp_d}{dt} = 0$ (Whole burden on producer).     3. If $\epsilon_s = \infty$, entire burden is on consumer.     4. If $\epsilon_s = 0$, entire burden is on seller.

Taxation and Economic Inefficiency

• Deadweight Loss (DWL): Inefficiency caused by consumers and firms changing behavior to avoid tax, resulting in non-execution of beneficial trades.
• Social Perspective: The demand curve represents Social Marginal Benefit (SMB); the supply curve represents Social Marginal Cost (SMC).     * Example: Gasoline tax of $1\,dollar$ per liter. Before tax: $100\,billion\,liters$; after tax: $90\,billion\,liters$. DWL equals the loss of surplus from the $10\,billion\,liters$ no longer produced.
• Elasticity and DWL:     * Higher elasticities (demand or supply) imply larger changes in quantity and larger DWL.     * With inelastic demand, DWL is limited because the quantity reduction is small, despite consumers bearing most of the price increase.

Tax Evasion and Tax Avoidance

• Tax Avoidance: Legal changes in taxpayer behavior to reduce liability within the law (e.g., exploiting loopholes or producing fewer items to pay less tax).
• Tax Evasion (Cheating): Illegal reduction of tax liability by concealing income or falsifying records (e.g., not reporting sales).
• Ways of Engaging in Fraud:     * Maintaining two sets of records.     * Underreporting income or under-invoicing.     * Smuggling goods to bypass custom duties.     * Paying employees "off the books."     * Barter transactions (in-kind) to avoid cash records.
• Positive Analysis Model of Evasion:     * Objective: Maximize expected income by hiding amount $R$.     * Marginal Benefit (MB): Equal to the tax rate ($t$).     * Marginal Cost (MC): Equal to the marginal penalty per Birr ($mp$) multiplied by the probability of detection ($\rho$).     * Optimal Evasion ($R^*$): Where $MB = MC$.     * If $t$ rises, $MB$ shifts up, and evasion ($R^*$) increases.     * If $\rho$ or $mp$ rises, $MC$ shifts up, and evasion decreases.
• Normative Approaches to Reduction:     * Moral Suasion: Appeals to civic duty.     * Public Education: Teaching the benefits of taxes for funding social programs.     * Transparency: Showing exactly how revenue is spent.     * Recognition Programs: Awards for compliant taxpayers.

Principles of a Good Tax System

• Equity: Fairness via ability to pay.     * Vertical Equity: High incomes pay proportionally more.     * Horizontal Equity: Equal incomes are taxed equally.
• Certainty: Taxpayers must know the amount, time, and mode of payment clearly.
• Convenience: Collected at a time feasible for taxpayers (e.g., salary earners pay at payday; farmers pay after harvest).
• Economy: Administrative costs of collection should be kept low relative to revenue.
• Neutrality/Efficiency: Minimizing distortions to market prices to stay near Pareto-optimality.
• Simplicity: Laws should be easy to interpret without expensive consultants.
• Flexibility: Capability to adjust liabilities quickly for macroeconomic stabilization.

Optimal Taxation Dynamics

• Ramsey’s Rule: To minimize total excess burden, tax rates should cause the same percentage reduction in the quantity demanded across all commodities: $\frac{\Delta X}{X_1} = \frac{\Delta Y}{Y_1}$.
• Inverse Elasticity Rule: Derived from Ramsey's rule, stating $\frac{t_x}{t_y} = \frac{\epsilon_y}{\epsilon_x}$.     * Interpretation: Goods with lower demand elasticity (necessities) should be taxed at higher rates to minimize DWL.
• Equity Conflict: Necessities are often inelastically demanded; taxing them heavily burdens the poor.     * Adjustment: If society values egalitarian outcomes, goods favored by the rich (even if elastic) should be taxed higher than those favored by the poor.
• Corlett-Hague Rule: High taxes should be placed on goods that are complements to leisure (e.g., golf clubs), as leisure itself cannot be taxed directly.

Tax Reform and Hinrich’s Tax Transition Hypothesis

• Tax Reform: Substantial modifications to the system (e.g., Ethiopia’s 2003 introduction of VAT, adoption of tax register machines, or the FAYDA number).
• Motivations for Reform: Disincentive effects on labor, high evasion, failure to meet social goals, or excessive government size.
• Hinrich’s Four Stages of Tax Development:     1. Early Stage: Reliance on direct taxes (land, agriculture).     2. Transitional Stage: Modernization leads to reliance on indirect trade-related taxes (customs).     3. Intermediate Stage: Internal indirect taxes (consumption) rise due to monetization; modern direct taxes are introduced but yield little.     4. Advanced Stage: Trade taxes decline; modern direct taxes (income and corporate) dominate.
• Progression Summary: Agriculture $\rightarrow$ Foreign Trade $\rightarrow$ Consumption $\rightarrow$ Income.