BAC 302 – TAXATION

LESSON ONE - INTRODUCTION TO TAXATION

1.2: Definition of tax

The most common definitions of tax are:
 A compulsory contribution levied by the Government (taxing authority) upon
which there is no quid pro quo on account of paying taxes.
 A diversion of resources from the private sector to the public sector
 A leakage from the circular flow of income.

1.2.1 Tax characteristics

 It is compulsory: If a tax has been imposed on a person or institution, they are
expected to pay the required amounts. Failure to pay is illegal and one can be
charged with tax evasion.
 No quid pro quo: There are no direct benefits from the Government given to a
taxpayer on accounts of paying tax.
 Chargeable only by an authorized body: Only the Government has the power
and authority to impose and collect taxes from its citizens.
1.3: Reasons for taxation
a) Earning revenue: The Government is responsible for provision of services such as
education, infrastructural development, security, environmental maintenance, health
among others
b) Social welfare: To discourage excessive consumption and production of products that
may be harmful, the Government levies heavily the industries that provide substances
which are not necessarily illegal but are harmful to the society e.g. alcohol and tobacco
industries.
c) Stabilizing the economy: Taxes are used to ensure the economy of a country is stable
even in times of deflation and inflation. When a lot of money is in circulation, taxes are
raised to reduce the purchasing power of individuals and the Government can recall the
excess money in this way and vice-versa.
d) Allocation of resources: The tax policy can be restructured in such a way that
resources are directed to a specific locality. This can be achieved through tax incentives to
businesses that are willing to operate in a region.
e) Protecting and encouraging local industries: Local industries are suffering from the
increased popularity and competition from imports. To ensure the local industries have a
fighting chance, the Government puts high levies on imports.
f) Distributing income fairly: In a progressive tax system, the Government has higher tax
rates for those who earn more among its citizens. This ensures there is a balance and
fairness in taxation as pertains to the proportion of the amount of tax paid in relation to the
income of an individual.
1.4 Principles of a good tax system
1. Principle of simplicity: A good tax system is easy to
understand and clearly interpret for the tax payer. A complex
system would encourage tax evasion.
2. Principle of diversity: It has an optimal number of taxes that
is not too few or too many. A system with one tax can be very
inequitable and unproductive. One with too many taxes is harder
to administer and can prove too complex for the tax payer.
3. Principle of productivity: The system should be able to raise
enough revenue for the government. It focuses on the widening
of the tax net rather than raising the taxes, so that a majority of
citizens contribute increasing the number of tax payers while
maintaining a low tax rate.
4. Principle of flexibility: a tax system should provide
allowance for the government to change or adjust the tax
provision as needed. The government should be able to adjust the
rate of tax and provisions in terms of who should pay such a tax
5. Principle of economy: a good system should be economical for both the tax
payer and the collection agency. A tax payer should not be overburdened
unnecessary costs, additional costs in compliance with tax payments. The
agency too should not incur high costs when administering and collecting tax.

6. Principle of convenience: the system should be convenient for the tax payer
to comply with ay tax requirements. It should be convenient in terms of
payment, timing and location.

7. Principle of equity: it is the most fundamental principle of taxation. It

requires the system to be fair, equitable and just. The system should ensure an
equal sacrifice from the tax payers in terms of tax burden. To ensure this, a
good tax system should possess:
 Horizontal equity: tax payers with the same level of income are subjected to
the same level of taxation.
 Vertical equity: those with different levels of income should be taxed
differently.

8. Principle of allocative neutrality: the system should not distort or

negatively affect the flow of resources in an economy thus hindering economic
1.5 Classification of tax
Taxes can be classified in the following ways according to:
 Impact and Incidence
 Base
 Rate

1.5.1 According to the impact and incidence

The impact of tax refers to the point on which tax is imposed. The
incidence of a tax is the final resting place i.e. the person who is legally
liable to pay tax. Taxes can be:
 Direct tax
 Indirect tax

1. Direct tax
The burden and incidence fall on the same person hence the liability
cannot be shifted. Examples of such taxes are: PAYE, Corporate taxes,
Withholding taxes, Land rates, Stamp duty
2. Indirect taxes
The impact on this kind of tax is on one person but the incidence is on
another person. The tax burden can be shifted to another person e.g. VAT,
Excise duty, Import duty, Turn over tax.
1.5.2 According to base
This kind of classification is dependent on the tax base (the
object or activity on which a tax is levied). This object is
legally defined. Under this category there are:

 Income tax- this is tax levied on gains earned by individuals

and organizations.

 VAT-this is tax imposed on supply of goods and services

 Customs duty- this is imposed on imports or exports

 Excise duty- it is imposed on goods produced locally or

imported and targets specific commodities, e.g. alcohol.
1.5.3 According to rate
Taxes are classified according to how the rate of tax varies with the rate of
income. They can be classified as:
1. Progressive taxes: the rate of tax is directly proportional to the income
of an individual. The higher the income, the higher the tax levied
2. Regressive taxes: the rate of tax is inversely proportional to the income
of the tax payer. The higher the income, the lower the tax imposed. They
are punitive because they burden the low earners more.

N/B: In Kenya, there are no regressive taxes but the taxes that require
equal payment levels regardless of income can be said to be regressive e.g.
parking fees, advance tax by matatu owners.

3. Digressive taxes: it is a combination of both progressive and

proportional taxes in that the system is initially progressive then it
becomes proportional at a certain level of income.
4. Proportional taxes: the rate of taxation is fixed whether the income
level rises or falls. A flat rate is charged. For example corporate tax is 30%
for whatever taxable income, high or low. Other examples are VAT, excise
duty, customs duty etc.
ECONOMIC EFFECTS OF TAXATION

3.0 Introduction
This lesson will help generate a deeper understanding of the likely
effects of taxation on the macroeconomic activities in a country.

3.1 Main effects of taxation

Taxation has consequences that can be either favourable or non-
favourable to the carrying out of economic activities. The best
taxation system is one which has the best economic effects on general
economic activities. The effect of taxation can be addressed as
follows:

3.1.1 Effect of taxation on production

This can be categorized into four:
 Effect on the ability to work and save
 Effect on the desire to work and save
 Effect on the composition and pattern of production
 Effect on the supply of the factors of production
3.1.1.1 Effect on the ability to work and save
Taxes that reduce the tax payers’ efficiency negatively affect their ability to work and
thus production lowers. Taxes reduce the purchasing power of the people forcing
cutbacks on consumption expenditure. They also adversely affect the power to save too.
If the tax payer maintains his status even after tax, he will have to save less or not at all
as saving are dependent on the disposable income which lowers after taxation. This
effect is higher in lower and middle income groups as opposed on higher income groups
as higher income earners have a greater marginal propensity to save.

3.1.1.2 Effect on the desire to work and save

The desire to work and save is dependent on two factors:
1. The nature of taxes:
Heavy commodity taxes can bring about a reduction in production activities as demand
lowers when prices soar as a result of the taxation. Also, some taxes e.g. taxation on
inheritance or windfall gains would not necessarily have an effect on desire to work
because the individual is not directly involved in making the taxed money. High
progressive income taxes such as PAYE will discourage the willingness to work, invest
and save because the higher the income gained consequently attracts higher taxes. This
demoralizes the tax payers, especially when they cannot see any progress from proper
utilization of the revenues raised from taxation.
2. Nature of an individual’s reaction to taxes:

The immediate effect of a taxpayer to the announcement of tax proposals in the budget
may affect his willingness to work and save. This effect is known as the
announcement effect of taxation and it is dependent on an individual’s elasticity of
demand for income (the intense desire for obtaining a particular income). In most
cases this elasticity is inelastic because most people have a desire to maintain a
minimum standard of living, save for the future, acquire power and wealth. In the case
above, a raise in tax would push them to work more so as save more. If the elasticity
of demand is elastic an increase in tax would reduce the person’s desire to work and
save.

3.1.1.3 Effect on the composition and pattern of production

This can happen in instances where:

 The government imposes high taxes on socially undesirable products e.g. alcohol,
funds invested in these kinds of businesses can be diverted into other revenue streams.
 The government provides tax incentives to protect some local industries, resources
can be put in favourably to these protected sectors.
 High taxes in a country can lead to capital flight by foreign investors and as such
may disrupt production activities in some sectors.
3.1.1.4 Effect on the supply of the factors of production
The tax policy initiated by the government may have an effect on the supply of the factors
of production and that also affects the production. This effect can be analyzed as such:
Land:
Tax policies don’t have an effect on land supply, but it affects the utilization of land. The
government, in an effort to ensure land is developed and utilized, can introduce an idle land
tax.
Labour:
Much as tax policies have a minimal effect on the supply of labour in comparison to other
factors, certain tax policies may have an impact on the utilization of labour since they affect
the willingness of an individual to work. In developed countries people may opt to leave the
domestic labour market and relocate to tax havens, but in developing countries it may not be
such an issue as unemployment is very high.
Capital:
Taxes affect both the supply and utilization of capital. The major source of capital is savings
made by individuals and households therefore any effect taxes have on savings will
definitely have an impact on the capital base of the economy. On utilization of capital, the
effect of taxes is generated through the impact of these taxes on the returns of the business.
If the level of taxation on these returns is high, then people would shy away from
participating in the capital market.
Entrepreneurship:
A government tax policy may have an effect on supply and utilization of entrepreneurial
skills through profits. If the policy is such that the tax is so high on business profits it locks
out potential entrepreneurs who could set up businesses.
3.1.2 Effect of tax on distribution
A good tax policy is one that attempts to reduce the gap between the rich and the poor.
The effect of taxation on the distribution of income and wealth is dependent on:

3.1.2.1 Nature of taxation

A tax system that is regressive or proportional tends to increase the inequality of wealth
and income as it burdens the lower income group more than the higher income group.
A progressive system reduces the inequality because the higher income groups pay
more than the lower income groups in taxes such as PAYE.

3.1.2.2 Types of taxes

-Indirect taxes on the necessities of life create an inequitable level of income and
wealth as lower income groups spend a large amount of money to buy such necessities
as compare to their higher earning counterparts. The indirect taxes on luxuries also lean
more towards higher income earners because they tend to use such products more. This
also brings inequality in terms of income and wealth.
-Highly progressive rates of direct taxation have a way of reducing the gap between the
rich and the poor by reducing the concentration of wealth in the hands of higher
income earners.
3.1.3 Effect of taxation on investment

It is possible for a government to use tax incentives to

encourage both local and foreign investment.

-Very high taxes reduce the disposable income and savings

consequently. Any reduction in savings translates to reduced
investments due to lower capital.

-Heavy taxes on a business’ profits may also result in lower

levels of retained earnings.

-Very strict tax policies tend to impede both domestic and

foreign investments.

N/B: The Kenya government has been trying to streamline

the policies so as to attract more foreign investment.
READ ON THE FOLLOWING

Kenya's recent tax changes and regulations

https://
oxfordbusinessgroup.com/overview/duties-detail-look-tax-r
egulation-and-recent-changes

Kenya’s Tax System

1. https://
www.kra.go.ke/en/business/societies/paying-taxes/soci
eties-types-of-taxes

2. https://en.wikipedia.org/wiki/Kenyan_taxation_system
TO DO

TAX LEGISLATIONS AND TAXATION

OF
1. INDIVIDUALS
2. NGO’s
3. CO-OPERATIVE SOCIETIES
4. COMPANIES
5. PARTNERSHIPS ETC
IN KENYA

N/B: UNDERSTAND THE VARIOUS

INCOME TYPES EARNED BY THEM
AND THEIR TAXATIONS.