Course No. AIS 2305_Theory and Practice of Taxation_Lect Materials_Tax Theory_Jan 2012

BBA Course: AIS 2305. Theory & Practice of Taxation

Taxation: An Introduction

IntroductionThe fundamental economic problem of human being is surrounded by the unlimited wants and the limited resources. In the primitive economies, individuals use their resources to directly satisfy their wants. In the subsistence economies, economic activities are governed by the maintenance of existence and minimum standard of living. In the modern civilized world, maximum satisfaction is sought to be achieved from the use of limited resources through specialization of production and distribution systems. Which goods are to be produced, at what quantity, how to be produced and how the produced goods to be distributed depend on the type of the economy. Based on the economic systems of a country, the role of the government of that country is ascertained. In a capitalist economy (e.g., the USA), the size of the government is minimum and the role is of regulatory nature. In a socialist economy (e.g., Cuba), the role of the government is pervasive and the size of the private property is very minimum and the government produces and distributes all the goods. In a mixed economy (e.g., Bangladesh, the UK), both the private and the public sectors are of equal importance. Public finance (i.e., financing by the government) is thus dependent on the size and role of the government.

Public Finance and Tax as a Source of Public RevenueOrdinarily, Public Finance denotes the financial activities of the government. The word Public means ‘something operated by the government’ and the word Finance means ‘to supply with fund’. Thus, Public Finance is the funding by government. According to Harvey S. Rosen (1985), “Public finance, also known as public sector economics, focuses on the taxing and spending activities of government and their influence on the allocation of resources and distribution of income.” According to Philip E. Taylor (1970), “Public finance deals with the finance of the public as an organized group under the institution of government.” Public finance consists of mainly the following things:

Public revenue (Taxation, Printing currency, Charging for public goods, and Borrowing) Public expenditures: Revenue expenditures (Public servants’ compensation, costs of

consumable goods, such as medicine for hospitals, etc.) and Development expenditures (Establishment of new schools, hospitals, roads and highways, etc.)

Financial administration (Preparation of budget, passing and implementation of budget, government audit, etc.).

But in a narrow sense, public finance mainly deals with the public revenue and tax is one of the sources of public revenues. Tax is referred to as the compulsory, unrequited payments to general government. Tax influences the income, expenditure, consumption, savings, investment etc. of the citizens of a country.

Other Sources of Public Revenue vs. Taxation

As mentioned earlier, public revenue comes from four sources: Taxation, Printing currency, Charging for public goods, and Borrowing. Sources of public revenue other than taxation are discussed below:

Printing Currency: Government of a country is the authority that can print currency as a legal tender to finance its activities. But printing currency for additional financing is often called as the debasement of the currency, because it will reduce the purchasing power of the currency and create inflation. As the value of money falls, purchasing power is transferred from the holders of money to the government. This process has therefore been described as an ‘inflation tax’ by many economists.

Charging for Public Goods: Government may charge for the goods and services it provides. This is quite straightforward where the government operates like a commercial business. However, it would be very difficult, or even impossible, or very costly if possible, to charge individuals directly on the basis of the use they make of many government services. When the consumption is nonrival and/or exclusion is not possible/feasible, it is difficult to charge for public goods. Particular examples include defence and law enforcement.

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Borrowing: Government may raise money by borrowing. Government can borrow either from their own citizens or from overseas, but there are limits to the amounts that people are prepared to lend, even to government. Public debt has to be serviced. Interest has to paid on it, and the principal is also to be repaid. This means that who contribute to the financing on the expenditure through lending in the first instance, really do not lose. In the case of taxation, the taxpayers straight away lose some resources in favour of the government without any claim to their recovery. Debt financing, therefore, adds to the future budgetary commitments of the government authorities. Taxes raised to finance these payments impose a burden on the economy. Moreover, since it is the richer sections only which can subscribe to the public debt, debt servicing becomes a medium of redistributing national income in favour of the rich unless counter-balanced by taxation measures.

Taxation has its limits as well, but they considerably exceed the amounts that can be raised by resorting to the printing press, charging consumers directly, or borrowing. So while governments often use all four methods of raising resources, taxation is usually by far the most important source of government revenue.

Public Finance vs. Private FinanceSimilarities:

Related to satisfying wants Borrowing and repayment of debts Surrounded by economic activities such as production, investment and exchanges Maximization of welfare from the resources used in financing Creation of financial assets.

Dissimilarities:Point of Difference Public Finance Private Finance

1. Income and expenditure policy

Expenditure planning first, then raising funds Expenditure planning according to income

2. Sources of revenues

Taxation, printing currency, charging for public goods, and borrowing

Current income, past savings and personal borrowing

3. Compulsory acquisition of resources

Only government can use compulsory means (e.g., taxation) to acquire income or resources without any direct return

Private sector cannot use coercion to acquire income or resources in a civilized society

4. Forms of borrowing

Government can take non-repayable loan and can take loan internally or externally

Private sector cannot take non-repayable loan and cannot take loan internally

5. Rate of interest on borrowing

Very low due to very high credit-worthiness and sometimes due to use of coercion

Normally depends on credit-worthiness and collateral and usually high

6. Creation of currency

Government can print currency to finance, which is a back-borrowing and debasement of currency

Private sector cannot print currency

7. Principle of financing

Budget principle guided by decisions made through political and administrative system and based on general social objectives

Market principle guided by economic rationality and hence profit-oriented and follows quid pro quo (something for something)

8. Budget planning Government can adopt balanced budget, surplus budget (usually during inflation), or deficit budget (usually during deflation), and usually the budget is annual consistent with long-term planning (say, five-year plan)

Private sector can adopt balanced budget or surplus budget , but no deficit budget, and the budget may be for any period (one day or one week or one month)

9. Environmental influence

Government expenditures have specific objectives – full employment, economic growth, stabilization etc. and they are not influenced by the surrounding environment

Private sector expenditures are influenced by the surrounding environment, standard of living, consumption-habit etc.

10. Relationship between expenditure and welfare

Government expenditures do not follow the law of equi-marginal utility due to various social, economic and political influences, but government tries to maximize the social utility from the government expenditure

Private sector expenditures do follow the law of equi-marginal utility

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Point of Difference Public Finance Private Finance11. Time period of

expenditureMay be very long-term due to having perpetual entity by the state and return from some projects may be readily available

Usually short-term and return from investment is expected within a specific period

12. Publicity of income and expenditure account

Mandatory disclosure through budget announcement and various statistics on national income accounting

Usually kept confidential

13. Effect of income and expenditure

Effect on the whole society and far-reaching Effect on the individual family or at best on relatives and friends

14. Provision of insolvency

Provision of insolvency is not applicable in case of government

Provision of insolvency is applicable in case of private individuals under the Bankruptcy Act 1997

Importance of Public FinancePublic Finance is of high importance due to its following roles:

Controlling unfair competition or monopoly Provision of social goods to satisfy ‘merit wants’ (health, education, etc.) Reducing or prohibiting production or consumption of demerit goods Redistributing income and wealth Maintaining price stability Enhancing employment Maintaining socially desirable economic growth Reducing negative externalities in case of investments as far as possible Maintaining law, order and security Forming capital and investment, etc.

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Definition of Tax

“Tax” is derived from French word “taxe” which also means ‘tax’. Etymologically Latin word “taxare” is related to ‘tax’, which means “to charge”, i.e., “to demand or exact as a price etc.”

Tax is “a contribution exacted by the state” – Chambers English Dictionary (New Delhi: Allide Publishers Ltd., 1992).

“Taxes are what we pay for a civilized society” – Justice Oliver Wendell Holmes, Jr. (mentioned in the verdict of Compania de Tabacos v. Collector case in 1927)

“Taxes, after all, are the due that we pay for the privileges of membership in an organized society” – US President Franklin D. Roosevelt (1936).

“… a tax is the quota each citizen has to pay towards the cost of public services” – in the opinions of Adam Smith, Jean Baptiste Say, and David Richardo.

“The term taxes is confined to compulsory, unrequited payments to general government” – Organization for Economic Cooperation and Development (OECD) (1988).

“A tax is purely and simply a contribution, whether direct or masked, which the public authorities impose upon inhabitants or goods for the purpose of defraying government expenditure” – Paul Leroy-Beaulieu (1906).

“… a tax is a compulsory contribution imposed by a public authority, irrespective of the exact amount of service rendered to the tax payer in return, and not imposed as a penalty for any legal offence” – Hugh Dalton (1971).

“A tax can be defined meaningfully as any nonpenal yet compulsory transfer of resources from the private to the public sector, levied on the basis of predetermined criteria and without reference to specific benefit received, in order to accomplish some of nation’s economic and social objectives” – Ray M. Sommerfeld, H. M. Anderson and H. R. Brock (1980).

Characteristics of Tax1. Nonpenal: A tax is not imposed or collected as a penalty for any offence. A penalty (or fine)

is usually devised solely to dissuade a person from engaging in some specific act deemed detrimental to society. For example, a willful failure to control oneself from smoking in a public place where smoking is prohibited is subject to a penalty of Taka 50. Taxes, on the other hand, generally do not have such a specific objective, though they often are intended to influence more general behaviour.

2. Compulsory levy: A tax is a compulsory contribution or levy, if the taxpayer has attained the condition for the imposition of a tax, as laid down in the law. If the taxpayer fails to pay the tax timely, it will be exacted by the government through enforcement.

3. Sources of public revenue: Out of the major sources of public revenues, taxation is the most important source for the government. Other sources of public revenue are printing currency, charging for public goods, and borrowing from the public and other sources.

4. Direct unrequited: Taxes are collected by the government without references to a specific direct benefit provided to the taxpayers. Thus, taxation does not follow quid pro quo (something for something).

5. Representation: Taxes are imposed by a government only, where the government is represented by the general public. In accordance with the Article 83 of The Constitution of the People’s Republic of Bangladesh, “No tax shall be levied or collected except by or under the authority of an Act of Parliament.” Since the Parliament consists of the public representatives, so any tax imposed through an Act passed in the Parliament ensures ‘representation’ of the general public in a country.

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6. Transfer of resources from the private to the public sector: Through taxation, resources are transferred from the private sector to the public sector. Obviously no person or group of persons acting privately can, in the absence of a legal debt, compel any other person to transfer resources to him or her except under conditions of duress [i.e., threats or force]. A sovereign government can, through imposition of taxation, compel the general public to transfer their personal resources to the public exchequer.

7. Predetermined criteria: A tax can be distinguished also from an outright confiscation of resources (which can be very much like a tax in both result and objective) because a tax is levied on the basis of predetermined criteria and on a recurring basis. Predetermined criteria hopefully make a tax more equitable than confiscation, but this depends, of course, on the governmental body determining the criteria. In the free-world democratic countries, taxes must generally have a socially acceptable result.

8. Instrument for achieving special objectives: Taxes are a major tool by which the government directs and influences the reallocation of resources necessary to achieve a nation’s economic and social objectives. Withdrawal of tax from an existing sector, imposition of a tax on some new sector, or sometimes increasing or decreasing the tax rates are some common powerful instruments to influence the investment decision towards to particular sector, to enhance the price level for demerit goods to discourage their production or consumption, to curb or maintain price levels, etc.

Various Terms Related to Tax

It may be useful to define various terms which are used interchangeably with the term “tax” as follows:

1. Duty: Tax on commodity, i.e., goods and services (e.g., excise duty).

2. Toll: Tax given for using property of other person (e.g., toll on use of road or any bridge).

3. Cess: Tax in relation to any goods for specific purpose (e.g., cess on sugarcane in India).

4. Tariff: Tax or duty on goods imported and exported.

5. Rate: Tax imposed by a local authority (e.g., municipal authority) on its inhabitants or on the owners of property situated in the area of that local authority.

6. Assessment: The term refers to tax and something in addition to tax. Usually, any tax against which there is a direct return is called ‘assessment’ (e.g., National Insurance Contribution in the UK).

7. Imposition: Any tax or duty imposed according to legislative provisions or any Act passed by the Legislative Assembly.

8. Levy: Any tax, assessment, or fee imposed or collected. But fee is not a tax. The term ‘levy’ may be used for both ‘imposition’ and ‘tax-determination’.

9. Charge: The price taken for providing any goods and services. In case of pure public goods (e.g., defense service), it is difficult to take price. The cost of these services is borne by collecting tax and hence, tax is a charge.

10. Impost: Tax given for entry into a country.

11. Octroi: Tax given for entry into a city or municipal area.

12. Sur-tax/Surcharge: Additional tax given on the basis of usual tax.

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Objectives of Taxation

According to Musgrave and Musgrave (1989), the economic activities of the government are of three major types:

1) To remove the inefficiencies in allocation of economic resources under the market system;

2) To redistribute the income and wealth for the purpose of equitable distribution as per social consideration; and

3) To remove the cyclical fluctuations and ensure high level of employment and price-stability.

According to Margaret Wilkinson, in case of the first of the above three, taxation has its most important role. The allocation of resources to satisfy consumer wants is the principal objective of taxation. The market is very good in directing production in line with what people want. When this happens welfare is maximized and we say that the outcome is optimal, or efficient. But there are instances where market fails. There are some goods and services for which there is demand but which the market is unable to provide, and there are others which are under- or over-provided. Margaret Wilkinson refers to this situation as ‘market failure’, where the market system fails entirely to provide some goods (e.g., pure public goods), or underprovides (e.g., external benefits, or outputs supplied by monopolists) or overprovides (e.g., external costs). In case of market failure, the role of taxation has been described by Wilkinson as follows:

Market Failure and the Role of TaxationTHE CAUSE OF MARKET FAILURE

(1) (2) (3) (4)External Effects

Consumption: non-rival and/or exclusion not feasible

Positive Negative Monopoly

The market fails entirely – no

output

The market cannot take account of

external benefits and under-provides

The market cannot take account of

external costs and over-provides

The market under-provides: output is

restricted to raise price and produce monopoly profits

Public goods Mixed goods which benefit others as well

as their consumers

(a) Goods whose production imposes cost on others

(b) Goods whose consumption imposes cost on others

THE ROLE OF TAXATION

Taxation provides

government with

resources to supply these

goods

Either subsidies, negative taxes, to reduce price and raise output to the social

optimum;Or taxation provides resources for public

provision of optimal quantity

Taxation is necessary to raise price and reduce sales and output (and external costs) to the social optimum (or there may be legal

controls)

Regulation rather than taxation enables the public sector to control monopoly price and output decisions;

taxation can be used to redistribute monopoly

profitsSource: Margaret Wilkinson (1992), Taxation (Hampshire, UK: Macmillan), p. 7.

Nonrivalry: This refers to the absence of rivalry in case of consumption of some goods such that one person’s partaking of the consumption benefits does not reduce the benefits derived by all others. The same benefits are available to all and without mutual interference. Thus, in case of nonrivalry, the benefits of the concerned goods are wholly external. In case of nonrival consumption, an additional consumer adds nothing to cost.

Nonexcludability: This refers to the situation where one person’s partaking of the consumption benefits of some goods cannot be excluded from others’ consumption.

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Examples:Rival and Excludable

Bridge, which is not crowded but used by everybody

Rival but Nonexcludable

Travel on a crowded street during rush hours

Nonrival but Excludable

Bridge, which is not crowded and not used by everybody due to the existence of charge-free alternative

Broadcast with the use of jamming (made available only to those who rent clearing devices)

Nonrival and Nonexcludable

National defense

Measures to prevent air pollution

Externality: This refers to the consequences attending a transaction which affect others besides the transacting parties, especially when such consequences are not mediated by prices or accompanied by terms of payment as opportunities for negotiation that permit potentially affected third parties to influence the transaction. Thus, externality means a cost or benefit arising from any activity which does not accrue to the person or organization carrying on the activity.

External costs or diseconomies are damage to other people or the environment, for example, by radiation, river or air pollution, or noise, which does not have to be paid for by those carrying on the activity.

External benefits or economies are effects of an activity which are pleasant or profitable for other people who cannot be charged for them, for example, fertilization of fruit trees by bees, or the public’s enjoyment of views of private buildings or gardens.

Externalities may be technological or pecuniary. Technological externalities affect other people in non-market ways, for example, by polluting their water supply; they create a prima facie case for intervention in the interests of efficiency. Pecuniary externalities mean that other people are affected through the market: for example, a new industry may raise labour costs for other employers, or reduce the value of their capital by capturing their customers. Pecuniary externalities do not create any prima facie case for intervention, except possibly on grounds of income distribution.

Form the above diagram, we can see that taxation plays important role in some cases to rectify the market failure. In case of public goods, taxation provides government with resources to supply these goods. In case of positive externality, either subsidies or negative taxes can be provided to reduce price and raise output to the social optimum; or taxation provides resources for public provision of optimal quantity. In case of negative externality, taxation is necessary to raise price and reduce sales and output (and external costs) to the social optimum (or there may be legal controls). But in case of monopoly, regulation rather than taxation enables the public sector to control monopoly price and output decisions and taxation can be used to redistribute monopoly profits.

Thus, the objective of taxation can be enumerated as follows:1. Achievement of government social objectives: Taxation helps in achieving government social

objectives, such as provision of merit goods (e.g., health care, education, etc.), endowment allowances for the poor and destitute, etc., mainly through financing those expenditures.

2. Achievement of government economic objectives: Taxation is a very powerful instrument to influence savings, investments, price level and also motivation to work more. Thus, the government economic objectives of expanded industrialization, more economic growth, price-stability, employment generation, etc. are highly sensitive to the fiscal policies adopted by the government.

3. Discouragement of some consumptions: Since indirect taxation has direct bearing on price level, so this taxation can be used to raise the prices of demerit goods (such as tobacco or alcoholic products), so that their consumption can be discouraged.

4. Financing the public expenditures: Taxation is one of the most important sources of public revenue for financing the government expenditure. In case of market failure, government supplies public goods out of tax revenues. Government also provides subsidies to those who are engaged in supplying merit goods, so that these goods might be supplied at a cost below the production cost for social reasons.

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5. Redistribution of income and wealth: To ensure social justice and equity, taxation through various ways (such as progressive direct tax rates, rate differentiation, exemption, zero-rating, or other discriminatory treatment in case of indirect taxes) influences allocation of resources on production and consumption and hence contributes in redistribution of income and wealth. Taking taxes from the rich and spending that for the poor are also a common means of direct redistribution of resources.

6. Increase in economic efficiency: In economics ‘efficiency’ means that resources are used where (within a given income distribution) they contribute most to consumer welfare. Taxes may prevent the achievement of this result. This happens because they change relative prices in goods and factor markets, and consumers’, workers’, savers’ and investors’ behaviour is distorted as they attempt to reduce their tax liability. This reduces their welfare. A realistic definition of efficiency is that it is achieved if such distortions are minimized. However, taxes should be imposed and collected by the government in such a way, excess burden of a tax should be kept minimum, so that economic efficiency can be enhanced.

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Principles of TaxationPrinciples of taxation means the canons/guidelines considering which a tax should be imposed by the public authority.

Principles of taxation suggested by Adam Smith (1776): 1. Equity: According to Adam Smith, the canon of equity states that “the 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 revenue which they respectively enjoy under the protection of the State.” Here, “in proportion of their respective abilities” refers to that the feeling of tax burden should be equal to every taxpayer.

2. Certainty: 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.”

3. 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.” Thus, the mode and timing of tax payment should be convenient to taxpayer.

4. Economy: According to Adam Smith, “every tax ought to be contrived as both to take out and keep out of the pockets of the people as the little as possible over and above what it brings into the public treasury of the State.” That is, the cost of collecting tax should be minimum.

Comprehensive List of Principles of Taxation: 1. Financial Principles: Related to requirement of government revenue.

(1) Principle of Adequacy [adequate revenue](2) Principle of Flexibility [with respect to coverage and rates of tax to reconstruct the tax-

structure]2. Economic Principles: Related to reaction on the national economy due to imposition of any tax.

(3) Principle of Choosing Correct Sources of Taxation [not to tax income generating capital](4) Principle of Diversity [multiple types of taxes and rates of taxes]

3. Principles of Justice: (5) Principle of Universality [everybody should pay tax](6) Principle of Equity

4. Principles of Tax Administration: (7) Principle of Determinancy/Certainty(8) Principle of Convenience(9) Principle of Economy(10) Principle of Buoyancy [automatic increase in tax with the increase in gross domestic

product (GDP) without changing the tax rate or/and tax base](11) Principle of Simplicity [simple to understand and administer](12) Principle of Consistency [consistent with national macroeconomic policy](13) Principle of Productivity [productivity of revenue].

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Characteristics of a Good Tax

(1) Equity(2) Efficiency (effort to reduce extra tax burden)(3) Certainty(4) Simplicity and Evidence (simple enough for taxpayers to understand and should be evident

whether taxes represent the costs of public goods and welfare benefits)(5) Economy(6) Flexibility and Stability (flexibility to alter tax rates and the size and composition of tax

revenues for stabilizing the economy or to fit an incoming government’s philosophy and to fulfill their promises; stability enables individuals and companies to plan for tax ahead)

(7) Expenditure Restraint (to reduce one taka private expenditure due to one taka tax, so that public spending can be undertaken without inflationary pressure)

(8) Convenience(9) Motivation (for effort to work more, savings, investment, entrepreneurship)(10) Consistency(11) Productivity(12) Macro Economic Consideration(13) International Effects

Role of Taxation in Economic Development

In the light of the purposes of taxation (achievement of government social and economic objectives; discouragement/encouragement of some consumptions; financing the public expenditures; redistribution of income and wealth; increase in economic efficiency), the following roles of taxation can be identified with respect to economic development:

1. Financing public projects: Tax is the major government revenue used to finance the public projects including public sector industrial undertaking or infrastructural facilities or ventures producing pure public goods.

2. Ensuring price stability: Tax is often used as a powerful instrument to maintain the price stability.

3. Generation of employment: In case of government sector, the new employments in the expanded public sector are financed by tax revenue.

4. Encourage private sector industrialization: Through tax holiday, accelerated depreciation and other tax exemptions/relief, private sector industrialization is encouraged.

5. Encourage export and discourage imports to make the country self-dependent: Usually export sector is provided huge tax incentive (say, 10-year tax holiday for EPZ area, tax exemption on 50 percent of export income in other cases) and imports of finished goods are subject to very high taxation to ensure export-led and import-substitute economic policy.

6. Encourage savings and investment: Providing investment tax credit on individual savings and investment and also allowing a percentage of initial industrial investment as a deduction as “investment allowance”, savings and investments are encouraged.

7. Encourage foreign exchange remittance: By fully tax exempting the foreign exchange remitted through banking channel, foreign exchange earning of the country has been increased.

The term tax is confined to compulsory, unrequited payments to general government. It may be classified in numerous ways. But tax is the most important source of public revenue in comparison to other three sources such as “charging for public services”, “printing currency”, and “public borrowing”. Tax can be used as a powerful source of financing as well as an effective instrument to influence economic activities of a country and thereby, economic development may be guided as per the national economic policy.

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Impact, Incidence and Effect of a Tax

Impact of a TaxImpact of a tax is its first point of contact with the taxpayers. It is upon those who bear the first responsibility of paying it to the authorities, that is those have statutory responsibility of paying it to the Government.

Incidence of a TaxIncidence of a tax is defined as its final resting place. It is to be seen and judged in terms of money burden of the tax. To put it differently, the incidence of a tax is upon those economic units which finally bear the money burden of it and which are not able to pass it on to others. Incidence lies upon that final source from which tax money comes.

Effect of a taxWhen a tax is imposed and collected, it involves certain responses from taxpayers and the economy. Such responses can be of great variety and can profoundly influence the working of the economy in terms of production, growth, savings, investment, choice of techniques of production, regional imbalances, inequalities of income and wealth, and so on. These responses and their results are collectively called the effects of that tax. These effects can be the result of the fact of tax imposition itself and they could also follow from the process of shifting its incidence. Effects of a tax can be both beneficial and harmful. Harmful effects of a tax will be referred to as the burden of that tax.

Burden of a tax has two dimensions: money burden/formal incidence (the reduction in the disposable income of the taxpayers) and real burden (the loss of welfare to the taxpayers and the community as a whole, in terms of increasing unemployment, reduced production, etc.).

Money burden of a tax may be direct or indirect. Direct money burden refers to the amount of tax being paid by the taxpayers to the tax authorities and indirect money burden refers to the additional money expenses incurred by the taxpayers for tax payment.

Real burden of a tax may also be direct or indirect. Direct real burden of a tax will be the sacrifice of the welfare which the tax itself imposes upon the taxpayers, but not as net of the benefits, if any. Indirect real burden is the indirect loss of welfare which results from (a) interference with consumer choice, (b) changes in factor supply and hence total output, and (c) changes in employment through changes in aggregate demand.

Impact vs. Incidence of a tax The impact refers to the initial bearing of the tax while incidence refers to the ultimate bearing

of the tax. Impact is felt by the taxpayer at the point of imposition of the tax, while the incidence is felt by

the taxpayer at the point of settlement or rest of the tax. The impact of the tax is felt by the person from whom the tax is collected, while the incidence

is felt by the person who actually bears the tax liability. Impact of a tax can be shifted, but the incidence of a tax cannot be shifted.

Incidence vs. Effect of a tax A tax reduces the income of the person on whom the incidence rests, while the effect of the tax

is the pressure or influence of the incidence (such as forced reduction of consumption and investment for disposable income reduced by tax incidence).

The incidence of a tax is the direct money burden, and the effect of the tax is the indirect money burden.

The effects of a tax can be the result of the fact of tax imposition itself (impact) and they could also follow from the process of shifting its incidence.

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Shifting of Tax Incidence

Shifting of tax incidence refers to the process by which the money burden of a tax is transferred from one person to another. Shifting of tax incidence is done through the means of a price variation and it may be of the following types:

Forward shifting: If a tax incidence is shifted through a sales transaction, it is called forward shifting. For example, an excise duty imposed on a producer may be shifted to a consumer, or a value added tax (VAT) imposed on a seller may be shifted to a buyer. In case of multi-stage forward shifting of tax incidence, a tax incidence shifted from a seller to an intermediate purchaser who will also shift it to another buyer and so on until the tax finally settles on the ultimate purchaser or consumer, it may be called that the tax is being shifted onward.

Backward shifting: If a tax incidence is shifted through a purchase transaction, it is called backward shifting. If a VAT imposed on a consumer and he can shift it to the producer, or a VAT imposed on a buyer and he can shift it to the seller, then it will be backward shifting. Backward shifting may be through tax capitalization, when a tax affects the capital value of assets. If a tax changes the expected yield of an asset, then it will also change its market price. In other words, the tax has been capitalized. Say, a durable good is subject to a periodic tax (e.g., equivalent to previous annual licence fee on TV) and an equivalent of the future tax payments is found in terms of the present value (PV) of the periodic tax discounted on the basis of interest rate. If the purchase price of the durable item is reduced by a part or full amount of this PV by the purchaser, then it is called tax capitalization.

Theories of Tax Shifting Concentration Theory: This approach maintains that there is an inherent tendency for the

taxes to be absorbed by certain income classes (e.g., tax on wage or tax on land income only). Diffusion Theory: This theory asserted that all taxes are diffused among the members of a

community. Because of the constant interaction of sales/purchase transactions, eventually it becomes impossible to trace the final incidence of any tax and in reality all taxes get “diffused” in the economic system.

Demand and Supply Theory: According to this theory, a tax can be shifted only through a shift in the demand and/or supply curves and the sharing of the incidence will be determined by the demand and supply elasticities.

Demand and Supply Theory of Tax ShiftingAccording to the demand and supply theory of tax shifting, tax incidence is borne by buyer and seller as follows:

Buyer’s share of incidence=

es ……………………………………… (1)Seller’s share of incidence ed

where, es = elasticity of supplyed = elasticity of demand.

Thus, if ed = , es = 0, the entire incidence of the tax is on the seller. if es = , ed = 0, the entire incidence of the tax is on the buyer. if ed = es, the incidence of the tax is equally divided between the seller and the buyer. if es > ed, the incidence of the tax is in higher proportion upon the buyer than upon the seller. if ed > es, the incidence of the tax is in higher proportion upon the seller than upon the buyer.

e Curve e = e = 0

essupply curve parallel to X-axis parallel to Y-axis

Goods produced under constant returns

An upward shift in the supply curve will automatically mean an equivalent increase in the price being paid by buyer

ed demand curve parallel to X-axis parallel to Y-axis

Additional Factors Influencing Tax Shifting

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Main Factors Influencing Tax Shifting: Elasticity of supply Elasticity of demand

Additional Factors Influencing Tax Shifting Type of tax – transaction tax easier to shift Price being fixed and accepted as normal – difficult to shift through price variation Tax rate – small tax chosen to be borne by the seller in a competitive situation Tax on commodity having close and effective substitute – difficult to shift Geographical coverage of a tax – if tax not imposed in neghbouring areas, difficult to shift

General Effects of Taxation

Effects of Taxation are the changes in the economy resulting from the imposition of a tax system (or a variation in it). Usual working of tax measures in a market economy:

i) All tax measures would work through either influence on the demand and the supply forces in the market.

ii) The tax measures either reduce the disposable income of the buyers (individuals, firms and so on) and thereby affect their demand, or they have an important bearing upon the economy through supply efforts of taxation. Elasticity of supply (Es) and elasticity of demand (Ed) are the major determinants in the detailed results of taxation.

iii) On account of the shifting of incidence, both demand and supply reactions may get mixed up leading to further rounds of effects, which is called “announcement effects” (Pigou).

Taxation policy should be as follows to optimum allocation of resources at the equilibrium point where the “social indifference curve” is tangent with the “production possibility curve”.

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General Effects of TaxationEffect on Effects of Direct Tax Effects of Indirect TaxIncome Higher direct taxes reduce disposable

income by curtailing the income directly. In the countries where unemployment allowances are provided, the situation becomes worse when an unemployed gets employment but falls in the lower income-bracket, because then he/she will not receive the unemployment benefit and at the same time he/she has to pay tax. This is called ‘unemployment trap’.

Usually the imposition of an indirect tax increases the price of the concerned goods or services. Thus the purchaser has to pay more, which reduces the net income.

Savings and Investment

Higher direct taxes reduce the ability of the tax-paying individuals or enterprises to save or invest. But it depends on the extent of financing the enhanced tax from savings or consumption.

Usually it is said that higher indirect tax indirectly encourages savings, because it increases price and thereby reduces demand. But in the overall effect, higher indirect taxation decreases savings and investments.

Price Higher direct taxes have a deflationary effect on price by decreasing the demand. But labour organizations may create pressure to increase the wage level to meet the higher taxes, which may cause a cost-push inflationary effect.

Indirect taxation usually increases price level and it has an inflationary effect. But the extent of inflationary effect depends on the price elasticities of demand and supply. If the price elasticity of supply is more than the price elasticity of demand, then the price will rise and if the price elasticity of demand is higher, then the price will fall.

Initiative Higher direct taxes have a negative effect on initiative, because then the leisure will be more preferable to work. But it is sometimes said, due to higher direct tax some will do more works in order to maintain the standard of living.

Higher indirect tax has also a negative effect on the business community’s initiative, because it is seen as an impediment to their trade and commerce causing a price barrier.

Overall Economy

Other things remaining the same, as a result of higher taxation, aggregate demand of the economy will fall, which may cause an inflationary effect on the price and output levels. Balance of payments may be improved by decreasing the dependency on foreign aid. But the employment situation may be worsen due to the fall in aggregate demand. Besides, taxation may affect regional disparity, inequality between income and wealth, etc.

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Classification of Taxes

Taxes are of various types, when it is classified on the basis of different things as follows:

1. Number of taxes: (a) Single tax: When a country has only one tax, it refers to single tax.(b) Multiple tax: When a country has more than one tax, it refers to multiple tax.

2. Impact and incidence of taxes: (a) Direct tax: When both the impact and incidence of tax fall on same person or entity, it is

called direct tax (e.g., income tax, wealth tax, gift tax, inheritance tax etc.).(b) Indirect tax: When the impact and incidence of tax fall on different persons or entities, it

is called indirect tax (e.g., value added tax, customs duty, business turnover tax, etc.).3. Structure of tax-rates:

(a) Proportional tax: When the tax increases (decreases) at a constant rate with the increase (decrease) in tax-base, the tax is called proportional tax.

(b) Progressive tax: With increase (decreases) in tax-base, if the tax increases (decreases) at a higher (lower) rate than the rate of increase (decrease) in the tax-base, the tax is called progressive tax.

(c) Regressive tax: With increase (decreases) in tax-base, if the tax increases (decreases) at a lower (higher) rate than the rate of increase (decrease) in the tax-base, the tax is called regressive tax.

Table-1: Example of Proportional Tax, Progressive Tax, and Regressive TaxTax-Base

(Tk.)Proportional Tax Progressive Tax Regressive Tax

Total Tax (Tk.)

Marginal Tax Rate

Total Tax Marginal Tax Rate

Total Tax Marginal Tax Rate

10,000 1,000 10% 1,000 10% 1,000 10%20,000 2,000 10% 2,500 15% 1,900 9%30,000 3,000 10% 4,500 20% 2,700 8%40,000 4,000 10% 7,000 25% 3,300 6%

4. Subject-matter of taxes: (a) Personal tax: When tax is imposed on person or entity, then it is called personal tax.(b) In rem tax: When tax is imposed on goods, services, or property (i.e., other than on

person or entity), then it is called in rem tax.

5. Elasticity of taxes:

(a) Elastic tax: When a tax produces more revenue with increase in tax rate and/or tax-base, then it is called elastic tax.

(b) Inelastic tax: When a tax produces equivalent or lower revenue with increase in tax rate and/or tax-base, then it is called inelastic tax.

6. Classification of tax-bases:

(a) Tax on income: When tax is imposed on income of the taxpayer, then it is called tax on income.

(b) Tax on wealth: When tax is imposed on wealth of a taxpayer being the owner of the wealth, then it is called tax on wealth.

(c) Tax on transaction: When tax is imposed on the value of a transaction or on the quantity of goods or services under a transaction, then it is called tax on transaction. The tax is called ad valorem tax if it is imposed on the value of a transaction, and it is called specific tax if it is imposed on the quantity of goods or services transacted.

(d) Tax on people: When a tax is imposed per capita, then it is called tax on people or head/poll tax.

7. Increase or decrease in public revenue:

(a) Positive tax: When a tax contributes positively towards the national exchequer (i.e., when government revenue is increased), then it is called positive tax. This is the real tax.

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(b) Negative tax: When a tax contributes negatively towards the national exchequer (i.e., when government revenue is decreased), then it is called negative tax. In economics, this is called transfer payments.

8. Collector of taxes:

(a) Central tax: When a tax is collected by a central government, it is called central tax (e.g., income tax, customs duty or value added tax collected by the National Board f Revenue).

(b) Local tax: When a tax is collected by a local government (e.g., union parishad, municipal authority, or city corporation), it is called local tax (e.g., holding tax collected by the Dhaka City Corporation).

Choice of Taxes between Proportional and Progressive Taxes

Proportional Tax Progressive TaxArguments in favour

1. Complexity in deciding upon a precise and appropriate degree of progression, and proportional tax is considered as better alternative

2. Does not effect the relative position of the taxpayers

3. Simplicity and uniformity4. Willingness to work more and save more

of the taxpayers not adversely affected as in case of progressive tax

5. Neutral tax in terms of allocation of resources of the economy to different uses (since all taxpayers lose the same proportion of their purchasing power)

6. Principle of equality justified on the ground that money burden of tax increases in the same proportion as the tax-base increases

1. Consistent with the ability-to-pay principles

2. Contribution to economic growth and stability (due to variability of tax collection and effective rate with the business cycle and progressive tax is automatic and compensatory mechanism to maintenance of stability; progressive tax increases Average Propensity to Consumption which is necessary in depression)

3. Powerful instrument for reducing economic inequality

4. Minimizing aggregate sacrifice5. Economical from the viewpoint of

collection, as the collection cost does not rise with the increase in tax rates

6. Elastic tax system and public revenue can be raised at any time by increasing the tax rates and vice versa.

7. Best alternative to proportional tax

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Proportional Tax Progressive Tax

Arguments against

1. Numerous tax collection points and administrative unmanageability and not “economical”

2. Not consistent with the just and equitable distribution of tax burden, as it falls more heavily on the poor than on the rich

3. Widens the inequality of the distribution of income and wealth

4. Possibility of being less revenue-yielding, since the tax rate for the rich and the poor is same and the State cannot obtain from the richer sections of the community as much they can give

5. May cause to social instability, because it is regressive in terms of real burden and oppressive to the poor

6. Cannot be an elastic tax system, if the tax rate for the small income-earner is already heavy

1. Fear of communism by the anti-Communists (as per Communist Manifesto, graduated income tax proposed to achieve a transfer of capital from the bourgeoisie to the proletariat)

2. Disincentive to work more and also to save and invest and thus possibility of adverse effect on production and capital formation

3. Political irresponsibility More tax collection and possible

increase in government spending It is possible that the richer minority

tends to be politicians (or to control politicians) and it seems unlikely that they would ever overtax themselves.

4. Excessive complexity Tax base cannot readily be subdivided

by the taxpayers in order to avoid effective progression (say, progressive sales tax is difficult, because numerous small purchase rather than large one)

Unintended high tax if tax base for a given period is inordinately large

5. Possibility of very great efforts to evade a steeply graduate tax

Choice of Taxes between Direct and Indirect Taxes

Distinction between Direct and Indirect TaxesPoint of

DifferenceDirect Tax Indirect Tax

1. Impact and incidence

In this case, both impact and incidence lie on same person or enterprise.

In this case, persons or enterprises on whom/which impact falls, they try to shift the incidence on others and hence, usually impact and incidence lie on separate persons or enterprises.

2. Subject-matter of tax

Direct taxes are usually personal taxes.

Indirect taxes are usually in rem taxes.

3. Elasticity of tax

If direct tax is progressive, then it is also elastic.

Indirect taxes are usually inelastic.

4. Tax-base Usually, the tax-bases of direct tax are income, wealth or people (in case of poll tax).

Usually, the tax-bases of indirect tax are transactions and production.

5. Tax collection cost

Collection cost of direct tax is usually high due to evading tendency of taxpayers.

Incidence of indirect tax usually falls on consumers and hence the producers or sellers collect the tax from buyers/consumers on behalf of Government. Thus, the collection cost is low.

6. Equity In reality, direct taxes are progressive and hence, largely equitable.

Indirect taxes are usually regressive and hence, inequitable.

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Arguments in Favour and Against Direct Tax and Indirect TaxTax Arguments in Favour Arguments Against

Direct Tax

1. Usually progressive.2. Redistribution of income and wealth in favour of

lower earning group.3. Revenue increases with the increase of income

(productive).4. Anti-inflationary.5. Easy to determine impact and incidence of tax.6. Educative value to taxpayers by generating a

feeling of economic consciousness in the mind of people.

7. Certainty ensured since the taxpayers are alarmed in advance about the amount of direct tax, timing and mode of its payment.

1. Disincentive effect against motivation.

2. Stops or discourages work-effort and initiative.

3. Encourages tax-evasion and tax-avoidance.

4. Discourages domestic and foreign investment.

5. High collection cost.6. Reduces savings.7. Narrowness of scope.8. Unpopular.

Indirect Tax

1. Advantageous to pay and comprehensive tax payment.

2. Voluntary.3. Does not make any harm to work-effort and

initiative.4. Flexible.5. Can be used for special purpose.6. Tax-evasion is list possible.

1. Regressive.2. Penalizes certain consumption.3. Does harm to concerned industry.4. Increases price.5. Difficult to determine the impact of

incidence of tax.

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Business Taxation: An Introduction

Business Enterprises as a Taxpayer

Taxpayer is a person, or business entity or any other organization who/which is supposed to pay tax to the Government. Whether a business enterprise is a taxpayer or not, depends on its form. Common forms of business enterprises are:

Sole-proprietorship: one owner and fully managed and controlled by that owner. Partnership: more than one owner (at least 2, but not more than 20) and managed and

controlled by the partners (being the owners), but sometimes management may be hired. Company: more than one shareholder (owner) and there is a divorce between management

and ownership.

Question regarding whether the entity itself and/or the owners of the entity is(are) taxable is explained on the basis of following two concepts:

Pass-Through Entity Non-Pass-Through Entities

Pass-Through vs. Non-Pass-Through Entities

Pass-Through Entity: This entity is not taxable itself. The income of the entity will pass through the owners and is taxable after its accumulation with the owner’s other income.

Non- Pass-Through Entity: This entity is taxable itself. The income of the entity may be distributed to the owners and is (or is not) again taxable after its accumulation with the owner’s other income.

SOLE-PROPRIETORSHIP: The entity is not taxable for its income [i.e., pass-through entity]. The sole owner of the entity is taxable for the income of the entity, distributed/withdrawn or not.

PARTNERSHIP: The partnership firm is taxable for its income in first instance [i.e., non-pass-through entity]. But if the entity fails to pay tax on its income, then the partners are individually and jointly liable to pay tax on its income. The share of income (distributed or not) will be included in the total income of individual partners, and if the firm has already paid tax on its income, the share of income will be treated as tax-free income in the individual partner’s hand and it will be subject to tax rebate at “average tax rate” (ATR).

COMPANY: The company is taxable for its income always [i.e., non-pass-through entity]. The shareholders of the company are taxable for the income of the company, only if distributed to them (as dividend).

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Business Entity as Legal Taxpayer vs. Real Taxpayer

Question regarding whether the entity itself is a legal or statutory taxpayer or it can be able to shift the tax incidence on others or other can be able to shift their tax incidence on the entity is explained on the basis of following two concepts:

Legal Taxpayer: The taxpayer whose name is registered in the tax-authority’s list of taxpayers under some statutory tax provision.

Real Taxpayer: The taxpayer whose name may or may not be registered in the tax-authority’s list of taxpayers under any statutory tax provision, but practically tax has been shifted on them and tax is being really paid by them.

In this regard, answers to the following queries are important: Whether the tax incidence can be shifted on others? Whether the impact of the tax and the incidence of the tax are on same entity? Whether the impact of the tax on one entity and the incidence of the tax is on other entity?

Answers to the above queries may be as follows: Whether the tax is direct (there is no scope of shifting) or indirect (there is scope of shifting). In case of income tax (tax on interest income, dividend income, business profit, capital gain,

etc.) and property-related tax (gift-tax), both the impact of the tax and the incidence of the tax are on same entity.

In case of tax on business transactions/consumption (VAT, supplementary duty, turnover tax), tax on international trade (customs duty, VAT, SD at import stage), in case of tax on production (narcotics duty, VAT and SD), in case of tax on services (excise duty, VAT and SD), the impact of the tax on the entity on which the tax is imposed legally under some statutory provision and the incidence of the tax is on other entity or person who are the buyers of the goods and services from the selling entity.

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Tax Structure in BangladeshTax and Non-Tax Revenues in BangladeshTax Revenue Non-Tax RevenueNBR PortionTaxes on Income and ProfitValue Added Tax (VAT)Import DutyExcise DutySupplementary Duty (SD)Other Taxes and Duties

Dividend and ProfitInterest Administrative Fees and ChargesFines, Penalties and ForfeitureReceipts for Services RenderedRents, Leases and RecoveriesTolls and Levies

Non-Commercial SalesDefence ReceiptsOther Non-Tax Revenue and ReceiptsRailwayPost OfficesTelegraph and Telephone BoardCapital Revenue

Non-NBR PortionNarcotics and Liquor DutyTaxes on VehiclesLand RevenueStamp Duty (Non Judicial)

National Budget 2011-12 and Tax Structure Therein

Table 1: National Budget 2011-12 at a Glance(Amount in crore Taka)

Revenues/Expenditures ItemsActual

2009-10Budget

2010-11Revised 2010-11

Budget 2011-12

% ofTE

% increase

Revenue 75,905 92,847 95,187 118,385 72.4 24.4 Tax Revenue 62,485 76,042 79,052 95,785 58.6 21.2 NBR Tax Revenue 59,742 72,590 75,600 91,870 56.2 21.5 Non-NBR Tax Revenue 2,743 3,452 3,452 3,915 2.4 13.4 Non-Tax Revenue 13,420 16,805 16,135 22,600 13.8 40.1Total Expenditure (TE) 101,608 132,170 130,011 163,589 100.0 25.8 Annual Development Program (ADP) 25,553 38,500 35,880 46,000 28.1 28.2 Non-ADP 76,055 93,670 94,131 117,589 71.9 24.9Deficit (excluding Foreign Grants) (as % of GDP)

-25,703(3.7)

-39,323(5.0)

-34,824(4.4)

-45,204(5.0)

-27.6 29.8

Financing 25,073 39,323 34,824 45,204 27.6 29.8 Foreign Grants 3,218 4,809 4,224 4,938 3.0 16.9 Foreign Borrowing-Net 6,036 10,834 5,783 13,058 8.0 125.8 Domestic Borrowing 15,820 23,680 24,817 27,208 16.6 9.6 From Banking System (Net) -2,092 15,680 18,379 18,957 11.6 3.1 Non-Bank Borrowing (Net) 17,912 8,000 6,438 8,251 5.0 28.2Gross Domestic Product (GDP) 690,571 780,290 787,495 899,670 Tax-GDP Ratio 9.05 9.75 10.04 10.65

Note: “% increase” means increase in Budget 2011-12 over Revised Budget 2010-11.Sources: Compiled from Annual Budget 2011-12: Budget in Brief, pp. 1-2.

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Table 2: Tax Revenue Target in the BudgetTax Revenue Revised Budget 2010-11 Budget 2011-12 %

increaseNational Board of Revenue (NBR) Portion Crore Tk. % Crore Tk. %Taxes on Income and Profit: 22,105 27.96 27,561 28.77 24.68 Companies 12,820 16.22 17,561 18.33 36.98 Other than companies 9,285 11.75 10,000 10.44 7.70Value Added Tax (VAT): 28,274 35.77 34,304 35.81 21.33 VAT on Imports 11,850 14.99 13,739 14.34 15.94 VAT on Domestic Goods and Services 16,418 20.77 20,560 21.46 25.23 Turnover Tax (TT) 6 0.01 5 0.01 -16.67Customs Duty: 10,915 13.81 12,664 13.22 16.02 Import Duty 10,888 13.77 12,634 13.19 16.04 Export Duty 27 0.03 30 0.03 11.11Excise Duty 275 0.35 450 0.47 63.64Supplementary Duty (SD): 13,554 17.15 16,220 16.93 19.67 SD on Imports 3,770 4.77 4,373 4.57 15.99 SD on Domestic Goods and Services 9,784 12.38 11,847 12.37 21.09Other Taxes and Duties: 477 0.60 671 0.70 40.67 Travel Tax 477 0.60 671 0.70 40.67 Other Taxes and Duties 0.3 0.0003 0.4 0.0004 40.00

Sub-Total: NBR Portion 75,600 95.63 91,870 95.91 21.52Non-NBR Portion Narcotics and Liquor Duty 60 0.08 70 0.07 16.67Taxes on Vehicles 905 1.14 975 1.02 7.73Land Revenue 525 0.66 570 0.59 8.44Stamp Duty (Non-Judicial) 1,962 2.48 2,300 2.40 17.23

Sub-Total: Non-NBR Portion 3,452 4.37 3,915 4.09 13.39Total Tax Revenue 79,052 100.00 95,785 100.00 21.17

Note: “% increase” = increase in Budget 2011-12 over Revised Budget 2010-11.Source: Compiled from Annual Budget 2011-12: Consolidated Fund Receipts, pp. 5-13.

Table 3: Tax Structure in National Budget 2011-12(in crore Taka)

Tax Structure Revised 2010-11

% of Total Tax

Budget 2011-12

% of Total Tax

% increase

Direct Tax: NBR 22,582 28.6 28,232 29.5 25.0 Taxes on Income 22,105 28.0 27,561 28.8 24.7 Other Direct Taxes 477 0.6 671 0.7 40.7Direct Tax: Non-NBR 3,392 4.3 3,845 4.0 13.3Total Direct Tax 25,974 32.9 32,077 33.5 23.5Indirect Tax: NBR 53,018 67.1 63,638 66.4 20.0 Taxes at Import Stage 26,535 33.6 30,776 32.1 16.0 Taxes at Local Stage 26,483 33.5 32,862 34.3 24.1Indirect Tax: Non-NBR 60 0.1 70 0.1 16.7Total Indirect Tax 53,078 67.1 63,708 66.5 20.0Total Tax 79,052 100.0 95,785 100.0 21.2 (% of Total Revenue) (83.0) (80.9) Total Non-Tax Revenue 16,135 22,600 40.1 (% of Total Revenue) (17.0) (19.1) Total Revenue 95,188 118,385 24.4Revenue-GDP Ratio 12.09 13.16

Note: “% increase” = increase in Budget 2011-12 over Revised Budget 2010-11.Source: Compiled from Annual Budget 2011-12: Consolidated Fund Receipts, pp. 5-13.

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Course No. AIS 2305_Theory and Practice of Taxation_Lect Materials_Tax Theory_Jan 2012

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