Engineering Economics Lecture# 11
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Topics of the Unit
Principles of taxation
Adam Smith’s canons of taxation
Characteristics of a good taxation system
Theories of taxation
Classification of taxes
Taxation system of Pakistan
Partial equilibrium analysis, general equilibrium analysis of tax
Optimal taxation and income distribution
Tax rates and base – challenges in expanding base in developing
countries
Taxable capacity/potential
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Tax/GDP ratio, tax buoyancy, tax elasticity – why these are low in
Pakistan
Tax evasion and tax avoidance
Optimal user fees to generate non- tax revenues
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SOURCES OF REVENUE FOR A GOVERNMENT
1. Tax: `
A tax is a compulsory charge imposed by a public authority against which tax
payers cannot claim anything.
The essence of a tax, as distinguished from other charges by the govt, is the
absence of a direct benefit
Anyone refusing to pay tax is punished under law.
Nobody can object to taxation on the ground that he is not getting the benefit
of certain state services
It is the personal responsibility of the individual to pay taxes under all
circumstances,
There is no direct relationship between benefit and tax payment
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2. Fees
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•It is a compulsory payment paid by those who enjoy a service in return
•The fee is intended to cover part of the cost of the service rendered
•Fee is a payment to finance the cost of each recurring service
undertaken by the government, primarily in the public interest.
•A license fee is paid in those instances in which the government
authority is invoked simply to confer a permission or a privilege.
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3. Price
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In modern times public sector occupies a main position in economy
Public enterprises run side by side with private enterprises
The government may either sell goods or render services like train, city bus,
electricity (PESCO, TESCO,LESCO etc), transport (BRT/Metro Buses), posts and
telegraphs, water supply, etc.
The government also earns revenue from the production of commodities like steel,
oil, life-saving drugs, etc.
4. Fine and penalties:
These are the charges imposed on persons as a punishment for breaking of a law.
The main purpose of these is not to raise revenue from the public but to force them
to follow law and order of the country.
Traffic fine, court fine, any law violation fine
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5. Gifts and grants:
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Gifts are voluntary contribution from private individuals or non-government
donors to the government fund for specific purposes such as relief fund,
defense fund during war or an emergency.
However, this source provides a small portion of government revenue.
6. Printing of paper money:
It is another source of revenue of the government.
It is a method of creating extra resources.
This method is normally avoided because if once this method of financing is
started, it becomes difficult to stop it.
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7. Borrowings:
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Borrowings from the public is another source of government revenue.
It includes loans from the public in the form of deposits, bonds, etc.
and also from the foreign agencies and organizations.
In Pakistan , Government takes loans from Public, Banks, IMF, World
bank, USA, UK, Japan…
8. Others sources
•Escheats: when a person dies heirless or devote his property to state
•Forfeitures, rates etc
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HISTORY OF TAXATION
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History of taxation extends to time immemorial
Main source of Government revenue was a share of gross produce of all land varying
according to the quality of earth and the amount of labour necessary to cultivate it
Taxes existed in Egypt, Greece, Yemen, india, Roman empire thousands of years ago
It was known as scribe in early periods of Egypt
In Yemen, it existed in 5th Century BC
In India, It was called Bali centuries ago
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http://www.taxworld.org/History/history.pdf
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In times of war the Athenians imposed a tax referred to as eisphora.
No one was exempt from the tax, which was used to pay for special
wartime expenditures.
In roman empire, The earliest taxes in Rome were customs duties on
imports and exports
Caesar Augustus was considering by many to be the most brilliant tax
planner of the Roman Empire
Caesar Augustus instituted an inheritance tax to provide retirement funds
for the military.
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The tax was 5 percent on all inheritances except gifts to children and spouses.
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English and Dutch referred to the inheritance tax of Augustus in developing their
own inheritance taxes
During the time of Julius Caesar a 1% sales tax was imposed.
In 60 A.D. Boadicea, queen of East Anglia led a revolt that can be attributed to
corrupt tax collectors in the British Isles.
Her revolt killed all Roman soldiers within 100 miles; seized London; and it is said
that over 80,000 people were killed during the revolt.
The Queen was able to raise an army of 230,000.
The revolt was crushed by Emperor Nero and resulted in the appointment of new
administrators for the British Isles.
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WHAT IS A TAX?
Taxes are compulsory payments associated with certain activities.
Revenues collected through taxation are used to purchase the inputs necessary
to produce government-supplied goods and services or to redistribute purchasing
power among citizens (Hyman, 2011).
Adam smith: “A tax is a contribution from citizens for the support of the state.”
P. E. Taylor: ‘A compulsory payment to Government without expectation of
direct return in benefit to the taxpayer is known as tax’.
Prof. Bastable: ‘A tax is compulsory contribution of the wealth of a person or
body of persons for the services of public powers.
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According to Seligman: “A tax is compulsory contribution from the person to the
Government to defray the expenses incurred in the common interest of all, without
reference to special benefits conferred”
According to Musgrave ( ) Taxes are compulsory imposts, whereas charges and
borrowing involve voluntary transactions.
Dalton. “A tax is a compulsory contribution imposed by a public authority irrespective
of the exact amount of service rendered to the taxpayer in return”
The dictionary of Modern Economic: "Taxation means “Compulsory levies on private
individuals and organs tons made by government to raise revenue to finance expenses
on public goods and services and to control the volume private expenditure in the
economy.
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OBJECTIVES OF TAXATION
Government levies and collects taxes for various objectives.
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These objectives may be specific or general.
Specific Objectives
The basic purposes of levying taxes are as follows to:
1.Support the operation of government.
2.Influence the macro economic performance of the economy, the
government's strategy for doing this is called its fiscal policy.
3. Carry out the functions of the government such as national defense
and providing government services.
4.Redistribute resources between individuals or classes in the population.
5. Modify patterns of consumption or employment within an economy
by making some classes of transaction more or less attractive.
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General Objectives
1.Raising Revenue
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•The basic purpose of taxation is raising revenue.
• To render various economic and social activities, Government
requires large amount of revenue.
•To meet this enormous expenditure, Government imposes various
types of taxes in addition to the non-tax revenue.
2. Removal of Inequalities in Income and Wealth
•The welfare state aims at the removal of inequalities in income
and wealth.
•By framing suitable tax policy, this end can be achieved.
•It is stressed in the Canon of Equality.
•The progressive taxation on income and wealth and heavier
excise and customs duties, and taxes on luxurious goods are the
suitable examples in this regard.
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3. Ensuring Economic Stability
Taxation affects the general level of consumption and production.
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Hence, it can be used as an effective tool for achieving economic stability.
By means of taxation the effects of trade cycle i.e. inflation and deflation can be
controlled.
During the period of boom or inflation, the excess purchasing power in the hands of
people leads to rise in the price level.
Raising the existing tax rates or imposing additional taxes can remove such excess
purchasing power.
Then the abnormal demand will be reduced and the economic stability can be achieved.
At the same time, by providing grants, tax exemptions and concessions, production can
be encouraged thereby inflation is controlled.
Likewise, during the period of depression or deflation, the role of tax policy in the
economy is important.
Reduction in the existing tax rates and removal of certain taxes, consumption can be
induced which in turn results in increasing demand.
This encourages business activities, and the economic growth can be achieved.
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4. Reduction in Regional Imbalances
•It is normal that certain parts of the country are well developed,
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whereas some other parts or states are in backward conditions.
• To remove these regional imbalances, the Government can use
tax measures.
• By way of announcing various tax exemptions and concessions
to that particular backward regions or states, the economic
activities in those areas can be induced and accelerated.
5. Capital Accumulation
•Tax concessions or rebates given for savings or investment in
provident funds, life insurance, unit trusts, housing banks, post
offices banks, investment in shares and debentures of certain
companies etc. lead to large amount of capital accumulation which
is essential for the promotion of industrial development.
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6. Preventing Harmful Consumption
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Taxation can be used to prevent harmful consumption.
By way of imposing heavy excise duties on the commodities like
liquors, cigars etc., the consumption of such articles are reduced
to a considerable extent.
7. Beneficial Diversion of Resources
The imposition of heavy duties on non-essential and luxury
goods discourages the producers of such goods.
The resources utilized for the production of these goods may be
diverted into the production of other essential goods for which
various tax concessions are given.
This is called as beneficial diversion.
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8. Encouragement of Exports
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Now-a-days export oriented industries are encouraged by way of
providing various exemptions like 100% relief from income tax, free
trade zones etc.
It results in the large earnings of foreign exchange.
9. Enhancement of Standard of Living
•By way of giving various tax concessions to certain essential goods, the
Government enhances the standard of living of people.
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CANONS OF TAXATION
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CANONS OF TAXATION
1.The canon of equity/ability
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All citizens of the nation should contribute towards expenses of the
Government “as nearly as possible in proportion to their respective
abilities."
•This principle suggests that taxes should be based on the taxpayer's
ability to pay.
•It emphasizes that individuals with higher incomes or wealth should
bear a proportionately higher tax burden than those with lower incomes.
•The principle aims to achieve a fair distribution of the tax burden across
society..
The ability-to- pay taxes increases with the rise in income, thus making
the higher economic class to contribute more to the Government
revenue.
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2. The Canon of Certainty:
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In the words of Adam Smith “the tax which each individual is bound to
pay ought to be certain and not arbitrary.
According to this principle, taxpayers should have a clear
understanding of when, where, and how much they are required to
pay in taxes.
The tax laws and regulations should be transparent, stable, and
predictable, minimizing uncertainty and promoting compliance.
Must be clear to the taxpayer and to other persons- otherwise, the
taxpayer shall be at the mercy of the tax administrators who may increase
the tax rate as per their whims and fancies.
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3. The Canon Convenience
In the words of Adam Smith “every tax ought to be levied at the time,
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in the manner, it is most likely to be convenient for the contributor to
pay it”
The canon of convenience states that the tax system should be
convenient for taxpayers to fulfill with.
It implies that taxes should be collected in a way that minimizes
administrative burdens and costs for both taxpayers and the
government.
For example, when land revenue is collected from a farmer after
harvesting season, it is quite easy for him to pay the tax put if its
collected before harvesting season, it is most trouble-some inconvenient
to him.
Income tax also satisfies this canon because the salaried employees in
monthly installments pay it.
In short tax system should be such that its enforcement is certain.
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4. The Canon of Economy
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Adam Smith noted, "Every tax to be so contrived as both to take out and to
keep out of the pockets of the people as little as possible over and above
what it brings into the public treasury of the government
It suggests that the tax system should be designed in a way that
minimizes administrative costs and compliance burdens for both
taxpayers and the government.
The tax system should be economical to operate and the tax should be such
that the cost of its collection should be minimum.
The revenue form tax should be much more than the cost of its collection.
To achieve economy in taxation, simplicity is encouraged.
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5. Canon of Simplicity
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The good tax system should be simplicity so that taxpayers are understood that
system and it should not be too complicated.
That makes it difficult to understand and administer and breeds problems of
interpretation and legal disputed.
The tax policy should be simple and to the point.
The better tax policy is the simple one which requires fewer conditions or
assumptions.
The canon is meant to prevent harassment to taxpayers and corruption among the
staff of tax administration.
The tax system must be easy to operate.
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6. Canon of Elasticity
Tax system must be elastic and not rigid
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It should be subject to variation in surplus/Defict or need
7. Canon of Productivity:
Productivity has become a key issue with tax planners.
Economic growth has come to be firmly linked with gains in
productivity.
The canon of productivity requires that the taxes imposed by the State
provide sufficient revenue so that the government may not be required to
face financial difficulties.
Thus, a tax system should be capable of providing adequate revenue to
the State to enable it to perform its function satisfactorily.
The tax system should help to increase productivity in the economic
sectors.
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8. Canon of variety/ Diversity
Under diversification a multiple tax system is preferable.
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A government, which adopts variety or diversity as a growth plan, seeks to
enter into new tax system and process.
According to this canon, a multiple tax system should be preferred instead
of single tax system.
A single tax system is one where under only one tax be levied upon a person
i.e. he is to pay to the State only one tax, thereby the Government collects all
that a person has to pay to the state.
This will enable the state to distribute burden of taxation on every section
of the society.
Such a system is bound to breed a lot of uncertainty for the treasury.
It is also likely to be inequitable as between different sections of the society.
On the other hand, if the tax revenue comes from diversified sources, then any
reduction In tax revenue on account of any one cause is bound to be very small
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References
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Hyman.D.N. (2011). Public Finance: A Contemporary application of Theory to poicy.
Cengage Learning.
https://www.slideshare.net/HEMRAJ37/public-revenue-188244076
https://www.economicsdiscussion.net/india/government-revenue/sources-of-
government-revenue-9-sources-economics/26179
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