Lecture Notes XII Principles of Taxation

Ngamije Jackson:Umutara Polytechnic University(RWANDA)

Lecture Notes XII

Principles of Taxation

Is a compulsory contribution to support government activities, projects,

programs and to support public services need.

I. Forms of Taxation
Two Broad Categories

• Direct taxes-characterized by being paid directly and shouldered by the

tax payer

o Individual income tax

o Payroll tax- Social security, PAGIBIG, Philhealth
o Corporate tax-tax on the net income of companies
o Estate & Gift tax- tax on inherited wealth from one generation to
the next
o Real Property tax-tax imposed by local government for land
ownership

• Indirect taxes- tax paid that can be shifted or pass on to others by the
tax payer

o Custom duties (tariffs)- levied on imported goods

o Excise tax- taxes on goods like tobacco, alcohol, telephone
services, air travel, luxuries
o Sales tax (VAT)- a flat percentage tax on all retail sales of a
broad category of goods
o Privilege or Fixed tax-tax imposed on any company engaged on
business or any person pursuing an occupation or profession
o Others ( Gross receipt tax, documentary stamp, amusement tax)

II. Five Desirable Characteristics of Tax Systems

• ECONOMIC EFFICIENCY
- The tax system should not be distortionary
- The tax system should not interfere with the efficient allocation
of resources
Economic Impact of Taxation

o Behavioral effects
- Work, education, retirement
- Savings, investment, risk taking
- Energies devoted to avoiding taxes instead of creating
wealth
- Marriage and divorce
o Financial effects
 Fringe benefits
 Financial structure of firm
o Organizational effects
 Lecture Notes XII Principles of Taxation
Ngamije Jackson:Umutara Polytechnic University(RWANDA)

 Corporations versus unincorporated enterprises

 Discourage and encourage economic activity from taking
place within corporations, thereby changing the degree of
risk taking in the economy

o General Equilibrium effects

 Reduce savings and capital stock and in turn reduce the
productivity of workers and their wages
 Increase in the degree of inequality
o Announcement effects and Capitalization
 Future taxes on an asset reflected (capitalized) in the
price of the asset at the time the tax is announced

Taxes and Economic Efficiency

o Distortionary- are associated with actions an individual takes to avoid

tax

o Non- distortionary- (lump-sum taxes) are taxes that are fixed and
cannot be altered by any action that the individual can take

o Corrective taxes- taxes imposed to both raise revenue and improve the
efficiency of resource allocations
- Taxes on activities that can caused negative
externalities (pollution)

• ADMINISTRATIVE SIMPLICITY
- The tax system ought to be easy and relatively inexpensive to
administer
- Reducing administrative cost and increased collection efficiency
(BIR)

• FLEXIBILITY
- Tax system ought to be able to respond easily to changed
economic circumstances

• POLITICAL RESPONSIBILITY
- The tax system should be designed so that individuals can
ascertain what they are paying, and evaluate how accurately the
system reflects their perspective (transparency)
• FAIRNESS
- The tax system ought to be fair in its relative treatment of
different individuals
o Horizontal Equity- individuals who are identical should be treated the
same, and pay the same taxes

o Vertical Equity- individuals who have greater ability to pay or who are
better off or receive greater benefits from government services should
pay more taxes
 Lecture Notes XII Principles of Taxation
Ngamije Jackson:Umutara Polytechnic University(RWANDA)

o Income is the most often used as a basis of taxation, an indirect and

imperfect measure of both ability to pay and economic well being

o Lifetime consumption is equivalent to lifetime income, this is fairer

basis than annual income

o Lifetime consumption/income is a flawed measure of ability to pay: it

unfairly disadvantages individual who chooses to work hard rather than
enjoy leisure: its not a real measure of one’s opportunity set

o Benefit taxation is hindered by difficulties of measuring benefits,

especially for pure public goods

III. Approaches to Taxation

1. Benefit Approach- the payment of taxes is based on the benefits

received by the taxpayer from public services
2. Ability to pay approach- support of government functions should be
provided by the taxpayers on the basis of their relative abilities to
shoulder the tax burden.
a. Three sacrifice doctrines
i. The minimum sacrifice principle- this sacrifice doctrine
provides for the imposition of a tax which would entail
the lowest possible aggregate sacrifice in the
community, ie, the minimum sacrifice principle is one
way of allocating the tax burden in such a manner that
the sacrifice of the tax payers taken as a whole would
be at the lowest possible level.
ii. Proportional sacrifice doctrine- each individual should
contribute his tax share to the government such that
the ratio of the utility he foregoes by paying the tax to
the total utility of his pre tax income, is equal to the
same ratio with regard to every other individual tax
payer
iii. Equal absolute sacrifice doctrine- this sacrifice doctrine
is akin to the equal marginal sacrifice principle but, in
the former the equality of sacrifice requires that the
total utility to be foregone by an individual taxpayers
must be equal to what every taxpayer should forego.

IV. Tax Policy and Its Implication

Tax base- This is the item or the unit on which the tax is imposed
Rate of tax – the tax rate is expressed in terms of percentage

Regressive tax- is when the tax rate is higher on the smaller base compared
to the bigger base, thus as the tax base increases, the tax rate becomes
smaller
Example. Value Added Tax
 Lecture Notes XII Principles of Taxation
Ngamije Jackson:Umutara Polytechnic University(RWANDA)

Proportional tax- it exist when the tax rate does not change as the size of the
tax base varies
There is a constant proportion between the amount of tax and the tax
base.

Progressive tax- when the tax rate changes in the same direction as the
changes in the tax base
Example. Income Taxation

Degressive tax – is a tax wherein the tax rate does not increase as fast as the
increase in the tax base or it is a progressive tax in which the tax rate is
increasing at decreasing rate, or that the rate increases in a decelerating
manner

V. Shifting and Incidence

The theory of shifting and incidence is a field in public finance that

deals with the distribution of tax burden. In other words, it deals
with how much each taxpayers or group of taxpayers contributes to
the government, given the tax system of the economy.

The burden of the tax is defined as the amount of the tax involved

The subject of the tax is the individual who must pay the tax (also
termed as the statutory taxpayer)

Shifting- is the process of passing on, or transferring part or all of,

the tax burden from the subject of the tax to another individual

The burden of the tax is the tax rate. However, if the manufacturer
or importer need not carry the burden and he can pass on the tax to
his customers in terms of a higher price, customers eventually shoulder
part or the entire tax burden. This is an example of shifting.

A given tax may be shifted forward or backward, or may be

absorbed by the statutory taxpayer.

a. Tax is absorbed by the statutory taxpayer- shifting has not

occurred and the incidence is on the subject of the tax

b. Forward, shifting takes place when the price of the taxed

commodity was increased.

Example. If the price of beer rises because of the 27.5-centavo

tax

c. Back w ard sh i f tin g - when the price paid for the factors of
production involved in the manufacture of the taxed commodity
h as d e cre ase d
 Lecture Notes XII Principles of Taxation
Ngamije Jackson:Umutara Polytechnic University(RWANDA)

Example. If man u f ac turers of beer have been able to decrease the

salary of their emp l o y e e s o r t h e p r i c e a t w h i c h t h e r a w m a t e r i a l s
has been reduced because of the tax.

Incidence- - refers to the final resting or settling down of the tax burden
- It describes who actually bears the tax

VI. The Incidence of Taxes in Competitive Markets

In competitive markets, incidence depends on the elasticity of demand and

supply

A commodity tax is not borne at all by consumers if the demand curve is

perfectly elastic or by producers if the supply curve is perfectly elastic.

Its is borne completely by consumers if the demand curve is perfectly

inelastic, or by producers if the supply curve is perfectly inelastic

The Effect of Elasticity

Elasticity of Supply and demand: tax borne

by consumers

a) Perfectly elastic supply curve- the price rises

by the full amount of the tax, the entire
burden of the tax is on consumers
b) Perfectly inelastic demand curve- the price
rises by full amount of the tax, the entire
burden of the tax is on the consumers

The steeper the demand curve or the flatter the

supply curve, the more tax is borne by consumers

Therefore the less elastic then demand curve, and

the more elastic the supply curve, the more tax
will be borne by consumers
 Lecture Notes XII Principles of Taxation
Ngamije Jackson:Umutara Polytechnic University(RWANDA)

Elasticity of Supply and demand: tax

borne by producers

a) Perfectly inelastic supply curve- the price

does not rise at all; the full burden of tax
is on producers
b) Perfectly elastic demand curve- the price
does not rise at all; the burden of tax is
on producers

The flatter the demand curve or the steeper

the supply curve, the more the tax will be
borne by producers

Therefore the more elastic the demand curve,

and the less elastic the supply curve, the more
the tax is borne by producers

References:

Romualdez, Eduardo Sr. E., Yoingco, Angel Q. and Cosem, Antonio O.

Philippine Public Finance, Manila, Philippines, G10 Enterprise, 1994

Stiglitz, Joseph E., Economics of the Public Sector, 3rd edition, W.W.
Norton & Co., New York, 2000