TAXATION

Why do Governments charge taxes?

1. To finance public sector spending

a. Welfare / Development of the poor.
b. For provision of Public & Merit goods.
c. Funding infrastructure, which is so very necessary to attract foreign
2.
3.

4.
5.
6.

investment.
Redistribution of income (tax the rich, subsidize the poor).
For achieving macro-economic objectives
a. Reduce taxation during recession; and
b. Increase taxation during boom.
To discourage consumption of undesirable / imported goods.
For protecting the environment tax private cars and subsidize public transport.
Provision of Overseas aid / Regional assistance

What is a good tax?

Three Es of a good taxation scheme

1. Efficient - it should not reduce the incentive to work
2. Equitable - Fair to all (high for the rich, low for the poor)
3. Economical - cost of collection of tax should be low

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Other factors to be considered:

Convenient for the taxpayers Pay As You Go vs one-time
payment
Non Inflationary

Taxation systems

Progressive
rate of tax progresses

Proportional
rate of tax is always

Regressive
rate of tax regresses with

with an increase in income

proportional to income

an increase in income

1. Progressive system of taxation For example, in India, tax rates are as follows:
INCOME
0 200,000
200,000 500,000
500,000 1,000,000
Above 1,000,000

TAX RATE
NIL
10%
20%
30%

A progressive system of taxation is one where the rate of tax increases with an increase
in income, as is in India. This system is Equitable (implying fairness, justice) since it
levies a higher rate of tax on the rich and a lower rate of tax on the poor. However, such
a system could reduce the incentive to work (not Efficient).

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2. Regressive system of taxation

INCOME
0 200,000
200,000 500,000
500,000 1,000,000
Above 1,000,000

TAX RATE
30%
20%
10%
5%

A Regressive system of taxation increases the incentive to work. The more one
works and earns, the lesser (as a percent of income) is the person required to pay
in tax. Many taxation systems could be regressive in practice. For example, in
the USA, while the tax rates are higher as incomes increase (ie, progressive
system), there are plenty of exemptions available to the rich that could effectively
bring down their tax liability, making the tax system regressive in practice. In
fact, Warren Buffett recently declared that his secretary paid more taxes than he
did.
3. Proportional system of taxation
Russia follows a proportional system of taxation in case of personal income tax
(ie, taxation for individuals). The rate of taxation for individuals is a flat 13%,
irrespective of the income earned. In most countries, corporate tax and capital
gains tax are proportional in nature (ie, there is a flat rate of tax, irrespective of
the income).

Types of taxes

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DIRECT
Where the levy and the burden

INDIRECT
Where the levy and the burden do not fall on the

fall on the same person (ie, they

same person (ie, they are collected indirectly). For

are collected directly).

example, VAT (Value Added Tax) is levied on the

producer / seller but it is finally recovered from
the consumer. In other words, it is levied on the
producer / seller but the ultimate burden falls on

Example: Income tax, Wealth

the consumer.
Example: VAT, Entertainment Tax, Excise duty,

tax, Corporate tax, Gift tax,

Import Duty

Inheritance tax
Advantages:
1. Equitable since it is
based on ability to pay
(based on income levels).
2. Leads to Redistribution
of income
3. More predictable than
indirect taxes.

Advantages:
1. Difficult to evade.
2. Quite advantageous for LDCs since they
have a low income base. Besides, import
duties protect domestic infant industries
(though this can lead to inefficiency).
3. Cheap to collect.
4. Wider tax base.
5. Can be used to achieve selective aims for
example, to discourage cigarette smoking.
6. Tax alterations are easier than direct taxes.

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Disadvantages:

Disadvantages:

1. Easy to evade.
2. Reduce the incentive to

1. They are regressive in

work.
3. Reduces investment /
Aggregate Demand.

nature, hence not Equitable.

2. Can be inflationary.
3. Distort the market mechanism, by artificially
increasing / reducing price of a product.
4. Uncertainty difficult to predict.

As mentioned above, most LDCs have a higher proportion of indirect taxation because it
is more difficult for people to evade these taxes as compared to direct taxes. However,
indirect tax tends to be regressive and is therefore not equitable and fair. For the first
time since independence, in 200708, Indias direct tax collections were more than the
indirect tax collections, which a sign of progress.

Indirect Tax can either be AD VALOREM or FLAT TAX. AD VALOREM tax is when the
tax is levied as a rate on the VALUE of the good, whereas a flat tax is an absolute
amount of tax irrespective of the value of the good. AD

VALOREM

taxes

can

cascading and can increase the price of a good excessively.

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be

Mastaan Challenges:
1. What is the impact of taxation on:
1.
2.
3.
4.

Growth
Employment
Inflation
Balance of Payments

2. What is the appropriate level of taxation? (Read Thank you, Mr Laffer)

3. Should a country rely more on direct taxation or on indirect taxation?

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