Concept Of Taxation: Economics Lesson Note

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Lesson Note

Subject: Economics

Topic: Public Finance

Subtopic: Taxation

Learning Objectives: By the end of the lesson, the learners should be able to;

Define tax and taxation,
Explain five reasons why Government Impose taxes,
List and explain two types of tax,
State the merits and demerits of each type of tax.

Discussions

Taxation

Taxation may be defined as the act or method of imposing a compulsory levy by the government or its agency on individuals and firms or on goods and services. Tax on the other hand is defined as a compulsory levy imposed on government or its agency on individuals and firms or on goods and services.

Features or Characteristics of Tax

i. It is a compulsory levy that must be paid by individuals or corporate bodies.
ii. It is levied by the government or its agency
iii. It is a payment made as a sacrifice.
iv. Tax is meant for the general welfare of everybody.
v. Tax payment has age limit, e.g people must attain certain age level before they can pay tax.

Principles of a Good Tax System

Adam Smith in his book Wealth of Nation has laid down certain principles of a good tax system which he called canons of good tax system. These principles include:
i. Equity or ability to pay: People should be made to pay tax according to their abilities. This implies that tax revenue should be raised without causing undue hardship to the tax payer.
ii. Economy: The principle states that the cost of tax collection should be cheap relative to the revenue yield.
iii. Convenience: A tax should be convenient as to form, time and place of payment. For example, an import duty should be duly paid as the imported goods arrive the country.
iv. Certainty: The tax should be certain and clear to everybody concerned. The time of payment, the number of payment and the amount to be paid should be clear and plain to the tax payer.
v. Revenue yield: From the standpoint of government, the total revenue that a tax yields is of considerable importance. Government are comfortable with the taxes that provide a fairly predictable and steady income.
vi. Neutrality: An important consideration in evaluating tax is how the tax affects production, savings and people’s willingness to work. A good tax system should not interfere unnecessarily with the supply and demand for goods and services.
vii. Benefits-receive principle: It is argued that those who benefits most from government supplied goods or services should pay the taxes necessary for their financing. For example, petrol taxes are typically earmarked for financing road construction and repairs, toll gates etc.
viii. Flexibility: The tax system should be flexible enough for adjustments when the need arises.
ix. Simplicity: A tax system should not be difficult to administer and understand. It should not cause problems of differences in interpretation.

Reasons Or Why Government Impose Taxes

There are many reasons why government or its agencies impose taxes on individuals or corporate bodies. Tax is known to be used to improve the economy of a country. The reasons for the imposition of tax include:
i. To raise revenue: Taxes are used to raise revenue for government. Through this, money required for the provision of essential services, general administrative purposes and finanacing of capital projects are made available.
ii. To redistribute income: Through the Pay As You Earn (P.A.Y.E) system, government can narrow the gap between the rich and the poor by introducing progressive taxation.
iii. Discouragement of production and consumption of harmful goods: Taxes are used to discourage the production and consumption of harmful goods. Indirect taxes imposed can lead to higher prices which can discourage the consumption of certain goods.
iv. To control inflation: Taxes can be used as anti-inflationary devices. Government can do this by increasing direct tax without increasing its expenditures.
v. To protect infant industries: Taxes can be used to protect newly established industries from competition with foreign firms.
vi. Prevention of dumping: Taxes are used to prevent dumping by the imposition of high import duties on foreign made goods. Dumping is a condition in which goods are sold abroad at cheaper prices than are sold in the country in which they are produced. Dumping ruins local industries easily.
vii. Direction of production and investment: Taxation can be used to direct production and investment, e.g tax exemptions or rebates for industries located in rural areas.
viii. Promotion of economic growth: Taxes can be used to promote economic growth. Government can reduce taxes on company profits so that these profits are ploughed back into business to aid expansion and stability.

Economic Effects of Taxation

i. Effect on production: Production will be affected or reduced if excise duties are high.
ii. Effect on inflation: An Increase in indirect taxes and a decrease in direct taxes by government can lead to increase in the volume of money in circulation thereby leading to inflation.
iii. Effect on consumption: Consumption of some harmful goods can be reduced if government imposes heavy tax on such harmful goods.
iv. Effect on investment: Imposition of high excise duty, company tax etc on investors by government will discourage investors from investing in businesses.
v. Effect on price of goods and services: When government imposes high excise duty this will make cost of production to be very high which could lead to high prices of goods so produced.
vi. Effect on salaries of workers: Income tax tends to reduce the disposable income of the workers.
vii. Effect on demand and supply: High indirect taxes will make demand and supply to be low as few goods will be produced because prices are very high.
viii. Effect on savings: High level of taxation on individuals and corporate bodies can lead to reduction in savings.
Problems Associated with Tax Collection

Difficulties Encountered By Tax Collectors In Nigeria Include;

i. Failure to fulfill Civic responsibilities: Many people do not fulfill their Civic responsibilities of paying tax as at and when due.
ii. Failure to declare real income: Many workers and corporate bodies, especially those in private firms, do not declare their real incomes
iii. Failure to meet people’s expectation: Many people have the belief that the money they pay as tax should be used only for the provision of social amenities. They will result payment of tax if those anticipated amenities are not provided.
iv. Tax Evasion: High taxes scare potential payers away.
v. Insincerity of tax collectors: Majority of the tax collectors are not sincere as they pay a little of what they have collected to the government and put the remaining in their personal pockets.
vi. Lack of book of account: Majority of the traders and small scale businesses do not keep proper book of account for the purpose of proper tax assessment.
vii. Mismanagement of government fund: Embezzlement and misappropriation of government fund by those at the corridors of power usually kill people’s morale or interest to fulfil their Civic obligation of paying tax.

Incidence of Taxation

Incidence of taxation refers to the point at which the tax but finally rests. The burden here refers to the amount paid as tax. The incidence or burden of taxation therefore lies on the person who finally pays the tax.

Types of incidence of Taxation

1. Formal incidence: This refers to the initial effects of tax on the tax object i.e the tax payer. It shows where the initial burden of taxation lies. For direct tax, the initial burden of tax is borne by the payer. The producers or manufacturers bear the initial burden of tax in the case of indirect taxes.
2. Effective incidence: The effective incidence of tax makes reference to who bears the final burden of taxation. With reference to direct taxes, the payer bears the full (initial and final) burden of taxation. For instance, a person who pays income tax bears the full burden of tax and he cannot shift it to another person. In the case of indirect taxes, the burden of taxation may be borne by the producer (seller) or the consumer or shared between them. The extent to which either or both of them bear the burden of taxation will depend on the elasticity of demand for the commodity which is taxed.
i. Incidence of direct tax when demand is perfectly Inelastic: The burden of an indirect tax on a commodity whose demand is perfectly Inelastic is borne by the consumer. In this case, the whole tax burden can easily be shifted to the consumer by the producer (or seller) in the form of higher prices because increase in price does not bring about any change in quantity demand.

Fig .1: Incidence of tax when demand is perfectly Inelastic

In fig 1 above, the tax is represented by AB. This tax increases the manufacturer’s cost of production. Since the same quantity is purchased irrespective of the price, the manufacturer increases the price of the product from P1 to P2. The consumer bears the full burden represented by rectangle P1BAP2.
ii. Incidence of indirect tax when demand is perfectly elastic: If demand for a commodity is perfectly elastic, the producer or seller will bear the whole burden of taxation. This is so because any attempt to increase price will make the demand for the product fall to zero. The tax burden under this situation cannot be passed to the consumer.

In figure 2. below, the tax is represented by EF. Since the tax increases the manufacturer’s cost of production, the quantity supplied decreased from Q1 to Q2. However, the price remains at P since any attempt to increase price will make demand to drop to zero. The manufacturer or seller therefore bears the whole tax burden represented the rectangle PEFG.

Fig.2: Incidence of tax when demand is perfectly elastic

iii. Incidence of indirect tax when demand is moderately elastic or moderately Inelastic: If the demand is moderately elastic or moderately Inelastic, the burden of taxation will be shared between the producer (or seller) and the consumer. The more inelastic the demand for the commodity, the more the burden of tax is shifted to the consumer. On the other hand, the more elastic the demand for the commodity, the grater the burden of taxation the producer (or seller) bears.

Fig.3: Incidence of tax when demand is fairly elastic

In figure 3, the producer or seller bears the tax burden represented by P1H1J while the buyer bears P2GHP1. The producer therefore bears the greater burden. But in figure.4, the area which represents the burden borne by the consumer is larger than that of the producer or seller.

Fig.4: Incidence of tax when demand is fairly inelastic

iv. Incidence of tax when demand is Unitary: If demand is unitary, the tax burden is shared equally between the producer (or seller) and the consumer.
In figure 5 below, the producer passed half of the tax burden to the consumer in the form of higher prices. The tax represented by RT, and the price increases from P1 to P2. The tax burden borne by the consumer is represented by P1SRP2 while the tax burden borne by the seller or producer is represented by VTSP1. The two rectangles are equal because both the consumer and the producer bear incidence of taxation equally.

Fig 5: Incidence of tax when demand is Unitary

Types of Tax

There are two major types of tax. These are direct and indirect tax.
1. Direct Tax: Direct tax as the name implies refers to the type of tax imposed directly on income of individuals or organisations by the government or its agency. Such income would include wages, salaries, profits, rents and interests. The burden of direct tax is borne by the payers. The tax payers are usually aware of the payment of such tax.

Types of direct tax

i. Personal income tax: This is the type of tax levied on the income of an individual, usually during a period of one year. In this type of tax system, individuals are granted certain rebates such as whether married, number of children, etc and the balance of the income is then taxed. In Nigeria, personal income tax is based on Pay As You Earn (P.A.Y.E). In this system, individuals are made to pay according to their income and ability to pay. Personal income tax is usually progressive, i.e, the rate of tax increases as income of the individual increases.
ii. Company tax: Company tax, also called corporate tax, is the tax levied on the profits made by the company. Allowance is also given to companies in the area of expenditure and the balance, called net profit, is taxed.
iii. Poll tax: This is the type of tax operated on flat rate basis usually imposed on the income of some individuals. The tax is said to be regressive of his income.
iv. Capital tax: This is the type of tax levied on property or on capital assets. Such properties may include land, cars, personal houses, etc. When tax is levied on the property or assets of a dead person, such capital tax is called death duty. It is levied on the person who inherits such property.
v. Capital gains tax: A capital gains tax is the type of tax levied on the gains or profits derived from the sale of land and capital assets. An increase in the value of capital assets is referred to as capital gain.
vi. Expenditure tax: This is the type of tax levied on the part of a person’s income which is actually spent. It is not a very common tax in developing countries but it is used to encourage savings.

Advantages or Merits of Direct Taxes

i. They are progressive in nature: Income tax is usually administered with a graded scale, i.e the more or higher an income, the more tax the person has to pay.
ii. They are non-inflationary: They do not increase prices and, therefore, are not inflationary because money is taken from consumers and their purchasing power is thereby reduced.
iii. Reduce inequality of incomes: Direct Taxes are used to ensure the redistribution of income as the poor pays less while the rich pay more. By so doing, it ensures redistribution of income.
iv. Easy estimation of Revenue: Revenue accruing from direct taxes can easily be estimated by the government or its agency.
v. Certainty in tax liability: In direct tax, the payer knows what to pay while the government knows what is expected to be collected as tax.
vi. They are cheap to collect: Under the P.A.Y.E system, the cost of collecting direct tax is usually very small.
Disadvantages or Demerits of Direct Taxes
i. They reduce savings: When tax is removed from one’s income, savings may become very difficult.
ii. They discourage investment: High tax on individuals and corporate bodies discourages potential investors from investments.
iii. They are prone to evasion: Direct Taxes are usually prone to evasion by many income earners.
iv. They are inconvenient: Tax payers always feel the pains any time certain amount of money is deducted from their salaries.
v. Disincentive to hard work: High incidence of tax can discourage people from working hard as they always believe that the more one works hard, the higher the tax one has to pay.
vi. They reduce purchasing power: When tax is imposed on the income of a worker, the balance may be small thereby reducing the purchasing power of such income earner.
2. Indirect Taxes: Indirect taxes refer to taxes which are imposed or levied on goods and services. The producers or sellers bear the initial burden of tax before shifting them to the final consumers in the form of higher prices. Unlike direct tax, the tax payers under indirect tax are usually not aware of the amount being paid for such tax.

Types of Indirect Tax

i. Custom duties or tariffs: These are grouped into two:
a. Import duties: Import duties are taxes levied on goods imported or brought into the country from other countries. They are paid initially by the importer. The main purposes of import duties are to generate revenue for government, reduce importation of non-essential commodities, to correct an adverse balance of trade, to protect infant industries and also to prevent dumping of goods.
b. Export duties: These are taxes levied on goods sent out (exported) to other countries. Such tax is paid by the exporter.
ii. Excise duties: Excise duties are taxes levied on certain goods produced within the country, i.e locally manufactured goods.
iii. Sales tax: This is the type of tax levied on the same of certain commodities. The tax is collected either at the wholesale or retail stage and passed unto the consumers in the form of higher prices.
iv. Purchase tax: This is the type of tax levied on certain consumer commodities such as cars, television sets etc. The tax is usually collected at the wholesale stage. It is based on the value of goods under consideration. Luxury goods attract higher purchase tax than essential goods.
v. Value Added Tax (VAT): This is the type of tax imposed on goods and services at each stage of production. The burden of taxation is finally borne to the final consumers. VAT is used to generate revenue for the government.

Classification of Indirect Tax

1. Ad valorem tax: This is a form of Indirect Tax imposed on commodities in accordance with their respective values and at specific percentages. Luxury goods attract high percentage of tax than essential goods.
2. Specific tax: In this type of indirect tax, a fixed sum is imposed or levied per unit of a commodity, irrespective of its value, e.g equal percentage of tax is levied on both luxury and essential Commodities.

Advantages or Merit of Indirect Taxes

i. Source of government revenue: Indirect tax is used to generate substantial revenue for government.
ii. Less burden of tax: The consumers usually pays a smaller amount of tax thereby experiencing less burden.
iii. Protection of Infant industries: Indirect tax can be used to protect infant or local industries when heavy taxes are imposed on imported goods.
iv. To correct balance of payment deficit: If a country exports less and imports more, balance of payment deficit will occur. In order to correct the situation, high import duties are imposed to ensure Improvement in the balance of payment.
v. To check importation of harmful commodities: Commodities that are considered harmful are taxed heavily in order to discourage their importation.
vi. Easy and cheap to collect: As soon as a consumer purchases a taxed commodity, he has paid the tax.
vii. It leads to less squabbles: This is because the buyer of the commodity is not aware of the amount he is paying as tax when he purchases the commodity.

Disadvantages or Demerits of Indirect Taxes

i. Indirect taxes are regressive: In this manner, the burden of tax falls heaviest on those with smaller income as both the rich and poor pay the same amount of money on the same type of goods.
ii. High cost of collection: Taxes accruing from indirect taxes are difficult and expensive to collect and remit to the appropriate quarters
iii. They are inflationary in nature: Since the producer’s costs of production are increased by taxation, they would charge high prices. If such taxes are high, this may lead to inflation.
iv. It could lead to industrial unrest: Increase in the price of commodities will warrant demand for higher wages by workers and if such demand is not met, it could lead to industrial unrest or strike.
v. Difficulties in its determination: Indirect tax is always prone to difficulties in determining the actual amount to be paid as tax.
vi. Uncertainty in revenue generation: The amount of revenue that can be generated from indirect tax cannot be calculated with any degree of certainty.
vii. It discourages investment: High custom duties on raw materials or finished products do discourage prospective investors.

Systems of Taxation

Taxation especially direct tax can be classified according to the following systems. These are:
1. Progressive tax: Progressive tax is a form of tax in which the rate of tax increases as the income, stock of wealth or value of property to be taxed increases. This type of tax is graduated in such a way that its rate rises according to the level of income or wealth of the tax payer. People with higher income are taxed more heavily than those that receive low income. The tax burden increases with increasing income levels or as the amount of wealth possessed increases. A good example of a progressive tax is the Pay As You Earn (P.A.Y.E) system. Progressive tax is demonstrated by a graph as shown in fig. 21.6

Fig.6: Progressive tax

2. Proportional tax: A proportional tax is a form of tax in which the rate of tax is the same irrespective of the level of income or wealth. In other words, it is a system of taxation in which the payers pay the same percentage or proportion of their income (or wealth) as tax. A good example of proportional tax is the company tax in which companies are required to pay a fixed percentage of their profits as tax. Proportional tax is demonstrated by a graph in figure 7. below:

Fig 7: Regressive tax

3. Regressive tax: Regressive tax is a tax system where the tax rate decreases as income increases. In this case, the higher the income of a consumer, the lower the rate of tax. In regressive tax, a poor person pays a higher proportion of his income than a rich person. A good example of regressive tax is poll tax. Regressive tax can be demonstrated by a graph shown in fig. 8.

Fig. 8. Regressive Tax

Mathematical Approach to Taxation

Certain calculations are done in taxation and for proper understanding of it, it is very important to take note of the following terms:
i. Tax base: The tax base refers to the item or the object which is taxed. This includes personal income, imports and exports, company profits,.properties, goods for sale, etc.
ii. Tax rate: Tax rate refers to the percentage (or proportion) of tax base or tax object which is to be paid as tax, e.g 10% of income. An ad valorem tax, for instance, is expressed as a percentage. On the other hand, it could be a flat rate of tax, e.g #100 per adult male.
Tax rate =tax payment/tax base x100/1

iii. Disposable income: This is the type of income derived after tax has been deducted from gross income. In other words, disposable or net income is total income less tax.
Disposal income = Income – taxation or tax base – tax paid.

Worked Example

Determine the percentage rate of taxation paid by (i) Mr. Okafor in column X and Y of the table above.
(ii) Kolawole in column X and Y (iii) Alhaji Tanko in column Y.
(B) identify the systems of taxation employed in columns X and Y
Which of the income earners has the least burden under column Y
(C) If the government increaaes its rate of taxation to 20% flat rate, how much revenue will be generated from the payess.
ii. At 20% flat rate of taxation, calculate the disposable income of Mr. Okafor, Alhaji Tanko and Mr. Kolawole
Solution
(A) Tax rate =