Lecture Notes On

Introduction to Taxation Theory

Kotut C. Samwel, M. Phil (Economics), PhD(Economics ongoing)

Department of Economics, Moi University.
ECF 111 Introduction to Taxation Theory
Purpose
The main purpose of this course is to equip students with the basic
knowledge of tax environment and tools.
Course Content
Size and Scope of Government, Logic of Government Action , Introduction
to Taxation, Principles of Taxation (Incidence, Efficiency, Optimal Taxation),
Capital Taxation, Properties of the Personal Income, Corporation Income
Tax , Tax Reform, Deficit Finance, State and Local Taxation, Special Issues
in Taxation, Tax equalization, Taxation in Kenya.
Course Objectives
This course is aimed at introducing the students to:
a. Introduce learners to the different forms of Taxation
b. Equip the students with Principles of taxation
c. Expose the students to issues in taxation
Expected Learning Outcomes
By the end of this course the learner is expected to be able to;-
a. Appreciate the different forms of taxation
b. State the properties of efficient taxation system
c. Identify possible tax reforms
Learning and Teaching Methods
Lectures, Tutorials, Group Discussions, Presentations, Term Paper writing
and blended learning platform
Assessment weight
CAT’S 30%
End of Semester Exam 70%
Total 100%
Instructional Materials and Equipment:
LCD/Projectors; Test books;
Course Texts
1. Stiglitz, J.E., (2000), Economics of the Public Sector, W.W. Norton,
New York.
2. Rosen, H.S., (2002), Public Finance, McGraw Hill, New York.
References
1. Abelson, P., (2003), Public Economics, Principles and Practice, Applied
Economics, Sydney.
2. Friedman, David D. (December 1999). "Price Theory: an intermediate
text". South-Western Publishing Co
Taxation is a term for when a taxing authority, usually a government, levies
or imposes a tax. The term "taxation" applies to all types of involuntary
levies, from income to capital gains to estate taxes. Though taxation can be
a noun or verb, it is usually referred to as an act; the resulting revenue is
usually called "taxes."

Purpose of Taxation
The government came up with the body of Kenya revenue authority to
collect taxes from its people. Taxes play crucial roles in helping in the
development of various governments sponsored projects for better
performance. Several reasons make it important for taxation to be
conducted in the country and the following are some of the major reasons.
Raising revenue
The mount collected from people can be used to maintain the level of peace
and security of Kenya and also the social welfare of people. It is important
that taxes be collected from people so as to have ways of improving the
social lives of people in the various residents of the country.
Economic stability
The government needs to carry out taxation so that during inflation
unnecessary expenditure from people can be discouraged at greater levels.
Economic stability is well achieved of the Kenyan government has better
rates of taxation from its citizens without making the feel to be paying more
money.
Protection policy
The government should have policies that can be used to protect local
industries hence raises the amount of tax imposed on visitors or any other
foreign groups that have interest in carrying out trade with the nation of
Kenya. It is therefore important for the government to take the factor more
seriously.
Social welfare
Some commodities such as alcohol are harmful for human consumption
making it necessary for the government to discourage the continuous use of
such products by imposing heavy taxes on those that consume and use it for
their own reasons.
Fair distribution of income
The less disadvantaged groups of society have poor access to good facilities
due to high rates of inequality in the country. When taxes are charged, it
makes it easy for the government to distribute resources that are lacking to
the rural and poor areas of the country.

Full Employment:

Second objective is the full employment. Since the level of employment

depends on effective demand, a country desirous of achieving the goal of
full employment must cut down the rate of taxes. Consequently, disposable
income will rise and, hence, demand for goods and services will rise.
Increased demand will stimulate investment leading to a rise in income and
employment through the multiplier mechanism.
Price Stability:

Thirdly, taxation can be used to ensure price stability—a short run objective
of taxation. Taxes are regarded as an effective means of controlling
inflation. By raising the rate of direct taxes, private spending can be
controlled. Naturally, the pressure on the commodity market is reduced.
But indirect taxes imposed on commodities fuel inflationary tendencies.
High commodity prices, on the one hand, discourage consumption and, on
the other hand, encourage saving. Opposite effect will occur when taxes are
lowered down during deflation.
Control of Cyclical Fluctuations:

Fourthly, control of cyclical fluctuations—periods of boom and depression—

is considered to be another objective of taxation. During depression, taxes
are lowered down while during boom taxes are increased so that cyclical
fluctuations are tamed.
Reduction of BOP Difficulties:
 Fifthly, taxes like custom duties are also used to control imports of certain
goods with the objective of reducing the intensity of balance of payments
difficulties and encouraging domestic production of import substitutes.

Characteristics of an Effective Tax System

A good tax system should meet five basic conditions: fairness,

adequacy, simplicity, transparency, and administrative ease.

Although opinions about what makes a good tax system will vary, there is
general consensus that these five basic conditions should be maximized to
the greatest extent possible.
Fairness, or equity,
means that everybody should pay a fair share of taxes. There are two
important concepts of equity: horizontal equity and vertical equity.
Horizontal equity
means that taxpayers in similar financial condition should pay similar
amounts in taxes.
Vertical equity
is just as important, however. Vertical equity means that taxpayers who are
better off should pay at least the same proportion of income in taxes as
those who are less well off. Vertical equity involves classifying taxes
as regressive, proportional, or progressive.
 Regressive tax: A tax is regressive if those with low incomes pay a
larger share of income in taxes than those with higher incomes. Almost any
tax on necessities, such as food purchased at a grocery store, is regressive
because lower income people must spend a larger share of their income on
these necessities and thus in taxes. Oklahoma’s sales tax is one example;
lower-income residents pay a much larger share of their incomes for
groceries and other necessities than higher income ones, so the sales tax
takes more of their income.
 Proportional tax: A tax is proportional if all taxpayers pay the same
share of income in taxes. No taxes are truly proportional. Property taxes
often come closest since there is typically a close relationship between a
household’s income and the value of the property in which they live.
Corporate income taxes often approach proportional because one rate
applies to most corporate income.
 Progressive tax: A progressive tax requires higher-income
individuals to pay a higher share of their income in taxes. The philosophy
behind progressive taxes is that higher income people can afford and should
be expected to provide a bigger share of public services than those who are
less able to pay. The federal income tax is the best example of a progressive
tax; the Internal Revenue Service reports that the top one percent of
taxpayers by income paid 38 percent of federal income taxes in 2012.
While no system of taxes is perfect, it is important to seek horizontal equity
because taxpayers must believe they are treated equally. It is just as
important to seek vertical equity so government does not become a burden
to low-income residents.
Adequacy
means that taxes must provide enough revenue to meet the basic needs of
society. A tax system meets the test of adequacy if it provides enough
revenue to meet the demand for public services, if revenue growth each
year is enough to fund the growth in cost of services, and if there is enough
economic activity of the type being taxed so rates can be kept relatively low.
Simplicity
means that taxpayers can avoid a maze of taxes, forms and filing
requirements. A simpler tax system helps taxpayers better understand the
system and reduces the costs of compliance.
Transparency
means that taxpayers and leaders can easily find information about the tax
system and how tax money is used. With a transparent tax system, we know
who is being taxed, how much they are paying, and what is being done with
the money. We also can find out who (in broad terms) pays the tax and who
benefits from tax exemptions, deductions, and credits.
Administrative ease
means that the tax system is not too complicated or costly for either
taxpayers or tax collectors. Rules are well known and fairly simple, forms
are not too complicated, it is easy to comply voluntarily, the state can tell if
taxes are paid on time and correctly, and the state can conduct audits in a
fair and efficient manner. The cost of collecting a tax should be very small in
relation to the amount collected.

Tax effort, revenue potential, tax space, and tax gap

The absolute tax effort, or the ratio of actual tax collected to GDP, is a good
indicator of the tax collection trends of a single country over a period of
time.
However, this ratio does not capture the tax potential or tax capacity of a
country, or whether a country is putting in enough effort to mobilize its
resources in comparison with other countries. To facilitate more effective
cross-country comparisons, several studies have used a regression approach
to estimate the tax potential.
Using this approach, the “revenue potential”, or “tax capacity” for a country
is first estimated as its predicted value from a regression that controls for
the individual characteristics of a country.
 Based on this, an index of the “relative tax effort”, or the actual tax
collected to the potential tax (both as a share of GDP), is computed to
facilitate easier cross country comparisons.
Distribution of Taxess
The Benefits Doctrine
 One of the doctrines of taxation known the benefits doctrine states
that people must pay taxes depended on the benefits they get from admin
services.
 This doctrine tries to make public commodities likewise to private
commodities. It looks reasonable that an individual frequently goes to the
motion pictures, pays more in aggregate tickets than an individual who
seldom goes.
 Likewise, an individual who receives benefit from a public commodity
must pay more for it than an individual who receives less benefit.
 The gasoline tax, for example, is sometimes justified the benefits
doctrine. In some states, revenues from the gasoline tax are used to
construct and preserve roads.
 For the reason those who purchase gasoline are the same individual
who use the roads, the gasoline are the same individuals who use roads the
gasoline tax might be viewed as a reasonable way to pay for this admin
service.
 The benefits doctrine can also be used to argue that affluent citizens
must pay higher taxes than the benefits of police protection from theft.
 Citizens with much to protect benefit more from police than more
then the deprived to the cost of preserving the police force.
 The same argument can be used for many other public services such
as fire fortification, nationwide defence and the court scheme. It is even
feasible to use the benefits doctrine to argue for anti deprived programs
financed by taxes on the affluent.
The Ability to Pay – Doctrine
 Another way to appraise the equity of a tax system is known the
ability to pay doctrine which states that taxes must be levied on a person as
per to how good that individual can bear the burden.
 This doctrine is at times justified by the claim they all citizens must
make a likewise sacrifice to assist the government. The enormity of an
individual’s sacrifice however is based not only on the dimension of his tax
payment however also on his earnings and other situations.
 For instance, a $100 tax paid by a deprived individual may require a
large sacrifice than a $1000 tax paid by an affluent individual.
 The ability to pay doctrine inclines to two consequent ideas of equity:
vertical equity and horizontal equity.
 Vertical equity states that tax payers with a greater ability to pay
taxes must contribute a huge amount. Horizontal equity states that tax
payers with likewise aptitude to pay must contribute the same money.
 Even though these ideas of equity are extensively accepted, applying
them to appraise a tax system is seldom straight forward.
Tax Incidence and Tax Equity
 Tax incidence – the study of who shoulders the burden of taxes is
fundamental to comparing tax equity. The individual who shoulders the
burden of tax is not always the individual who receives the tax bill from the
admin.
 Since taxes alter supply and demand they alter symmetry rates.
Consequently, they affect individual beyond those who as per statute
originally pay the tax.
 When appraising the vertical and horizontal equity of any tax, it is
vital to take these indirect consequences into consideration. Many debates
of tax equity overlook the indirect consequences of taxes and are based on
what economists contemptuously call the flypaper thesis of tax incidence.
 As per this thesis the burden of a tax like a fly on flypaper, sticks it
first lands. For instance, an individual not trained in economics might
debate that a tax on costly fur coats is vertically equitable for the reason
that most purchasers of furs are affluent.
 Even then if these purchasers can easily alternative other lavishness
for furs then a tax on furs might only minimize the sale of furs. Finally, the
burden of the tax will drop more on those who make and sell furs than on
those who purchase them.
 For the reason that most workers who make furs are not affluent, the
equity of a fur could be somewhat varied from what the flypaper thesis
indicates.
Conclusion : The Trade-off Amidst Equity and Effectiveness
 Approximately everybody accepts the equity and effectiveness are the
two most vital goals of the tax system.
 However frequently these two goals disagree. Many proposed
changes in the tax laws increase effectiveness while minimizing equity or
increase equity while minimizing effectiveness.
 People conflict about tax strategy frequently for the reason that they
attach diverse measures on these objectives.
 Economics on itself cannot establish the best technique to balance the
objectives of effectiveness and equity.
 This problem incorporates political philosophy as well as economics.
However economists do not have a vital responsibility in the political
conversation over tax strategy.
 They can shack light on the trade-offs that civilization countenances
and can assist us ignore strategies that forfeit effectiveness devoid of any
benefit in terms of equity.
 Lecture Two
Public Revenue and Taxation

Public Revenue
The income of government from all sources is called public revenue or
public income
Sources of Public Revenue:-
• Taxes :- A Tax is a compulsory payment imposed on the people or
company by government to meet the expenditure incurred on providing
common welfares to the people
• Commercial Revenue – Revenues which are derived by government from
public enterprises by selling their goods & services are called commercial
revenues. They are also known as prices as they come in the form of prices
of goods & services provided by the government. They include the
following.
• Postage.
• Railway faire
• Irrigation charges
• Prices paid for liquor in govt. stock etc .
It is not a very good source of the income of government

Sl. No. Price Tax

1 It is not a compulsory payment It is a compulsory
it is paid by person who contribution to be paid by
purchases goods and services every tax payer upon whom
sold by government. at is imposed

2 It gives direct benefit to the It does not give a directly

person who pays it for buying benefit to tax payer
goods services

3 Price is paid for goods & It is used for the common

services which are purchased benefit of all people
by the consumer. whether they pay tax or not

(iii) Administrative Revenue:- It includes fee, fines. Special assessment

and escheat
• Fees :- It is a payment which is paid to you for special services rendered
by them it sis only paid by those people who receive special benefits from
the services rendered by government com.
• License Fee : - It is a payment not to perform a service but to grant a
permission by a government. The registration fee for motorcycle, license for
keeping guns are some example of license fee.
• Fines & Penalties :- They are not important source of revenue. A fine
refers to the punishment imposed for the violation of law Example –
Motorists are charged for violating traffic rules & regulation
• Special Assessment : - Some times government undertake certain
improvements such as construction of road, provision of drainage, Street
lightning etc. they offer common benefits to society as a result of such
improvements the values of these properties rise and imposition of changer
in proportion to increase wealth is called special assessment .
It may be termed as special tax but it is not same as tax . It is levied after
the benefits have been conferred upon the payers while tax has no
guarantee of benefit. It is diff from fees, fees are the payments for certain
services rendered by government while special assessment lived for unrest
in one's property from some particular Services of government.

• Forfeiture :- It refers to penalties imposed by courts for the failures of

individual to appear in the courts, to complete contracts as stipulated.
• Escheat – Under the right of escheat the govt. May acquire the property,
bank balances etc. of a person without having any legal successor or
without writing a will this is also not an important source of revenue.
• Taxes :- A tax is a compulsory payment imposed on the person or the
companies by the govt. to meet the expenditure incurred on providing
common benefits to the people

Characteristics of Taxes:-
• Compulsory contribution: - Tax is a compulsory payment made by the
people to govt. no one can refuse the payment of tax to the government.
• Personal obligation : - Tax is a personal obligation on the tax payer. It
becomes his duty. To pay the tax if he comes under the taxable capacity
• General welfare : - Tax is a payment made by taxpayer which is used by
the government for the benefit of all the citizen.
• No Quid pro Quo: A tax is not levied for any specific services rendered
by the govt. to the taxpayer and individual cannot ask for special benefit
from the state in return for the tax payer by them thus the tax payer cannot
claim something equivalent to the tax paid from govt. Which means there is
no quid or quo in case of taxes ?
• Regular Payment : - Tax is payable regularly by the tax payer as
determined by the tax department.

OBJECTIVES OF TAXES /IMPORTANCE/SIGNIFICANCT

• Collection of Revenue : - The modern government performs a large no.
of functions for the welfare of societies for which they need income this
income can be earned by the government only through taxes which are
considered as the main source of revenues of government.
• Regulation of consumption & Production : - Taxation policy regulates
consumption and production of country. They are used to discourage
production and consumption like require, pan masala etc. they are also
effective in diverting the resources from production of non-essential
commodities to essential commodities.
• Protection to domestic industry : - custom duties are used to reduce
the imports of those goods which are domestically available and thereby
encourage the domestic industry. These taxes protect the domestic industry
from cut-throat foreign competition, this will also have favorable effect on
the countries balance of revenue.
• Reducing income inequalities :- Taxes are used for reducing
inequalities of income and wealth in a country by the following ways.
[Link] taxation on income would be great help in this regard it
means imposing heavy taxes on rich and low taxes on poor.
2. Inequality of income can also be reduced by imposing heavy taxes of
luxury goods and by giving tax concision on essentials goods which are
purchased by the people.
• Increasing the rate of capital formation :- The mains purpose of
taxation in poor country is go promote capital formation and economic
development. The revenue collected through taxes by govt. can be utilized
for the development of agriculture and industry and it can be used for
providing infrastructural facilities like transport & communication power
etc. on this entrepreneur can be motivated to set up industry in backward
regions of the country thus investment level goes up.
• Price stability :- It is the prerequisite for economic development to take
place taxes play a very important role for maundering price stability in the
times of inflation taxes reduced the purchasing power of people which
result to fall in aggregate demand in economy and thereby helps in
controlling prices. On the other hand taxes can be reduced during
deflection increase the aggregate remand.
• Development of backward region: - For the development of backward
region govt. gives tax concessions to the entrepreneur for setting up
industries in these regions.
• Economic growth : - Tax collected by govt. can be used in promoting
economic development of country. It can also be used for increasing the
productive capacity of diff. sectors of economy. Which with definitely
improve the growth rate of economy also.

TYPES OF TAXES:-
• Proportional tax: - In this type of tax all incomes are taxed at the
uniform rate. and it is not linked with the income of tax payer it is a simple
tax system and dose not have any harmful effects on willingness to work
and save but it is not based on principle of equality and revenue collected
through this tax is very less.
• Progressive tax : - Tax is said to be progressive when the rate of tax
increases as the taxpayers' income increases. Acc. to Dalton in progressive
taxes the higher the income the tax payer has higher proportionate tax to
pay. Progressive tax is based on principle of equity and it reduces the
inequality of income & health in helps in controlling inflation also. On the
other hand it has some disadvantages like there is an harmful effect on
willingness to work and save. On case of progressive taxation tax evasion is
common this case.
• Regressive Tax : - It is one in which the rate of tax decreases as the tax
payers' income increases. It is just opposite of progressive taxes regressive
tax are adjust and inequitable. They do not the principle or equity and they
promote inequalities of income in the surety.
• Digressive Taxation : - Under this system the rate of tax increases up to
action limit but after that a uniform rate is charged. It is formulate on slab
system in this case higher income group people have to make will sacrifice
as compared to lower income grow up people this is the case of income tax
in India as well.
Now the question arises out of above stated categories of tax systems which
is the best the answer would be we have to select the tax system which will
distribute tax system most equitably Regressive & digressive taxation can
not be accepted on the ground of equity but there has been heated.
Controversies regarding proportional and progressive taxation however
most of the economists are in favor of progressive taxation system.

DIRECT TAXES
Direct Taxes are those under which burden falls on the same person on
whom it is imposed, i.e. impact and incidence falls on the same person. eg:-
income tax, wealth Tax, Property Tax etc.
Merits of Direct Taxes:-
• Equitable: - Direct Taxes are based on the principle of equity or ability
to pay. The burden of a direct tax is equitably distributed on different people
& institutions as they are progressive in nature. Which means as income
increases the rate of income tax also increases
• Certainty: - Direct taxes are certain the tax payer knows how much tax
is due from him and when and how can he adjust his income and
expenditure. The govt. also knows fairly well the amount of revenue coming
to it
• Economical: - Direct Taxes are economical in the sense that the cost of
collection of these taxes is relatively low in the case of income tax it is
deducted at the source from salary of people. No separate staff is needed
for tax collection .
• Elasticity: - Direct Taxes are flexible and thus satisfy the canon of
elasticity. The govt. can increase or decrease rate of direct taxes according
to the requirement of economy. In case of war natural calamities or
emergency the state can raise the rate of these taxes in order to have larger
tax revenue and during depression rate of tax can be decreased.
• Civic consciousness: - Direct Taxes inculcate the spirit of civic
responsibilities among tax payers. Since tax payers provide funds from their
own pockets to the govt. they take been interest in seeing that these funds
are properly utilized. This public awareness plays an important tool in
checking the wastage of public expenditure .
• Simplicity: - Direct Taxes are very simple on nature it is easy to
calculate and understand these taxes.
• Reducing inflationary pressure: - Direct taxes are anti inflationary in
nature they help in controlling inflation by moping up the excessive
purchasing power of community.
• Reduces inequalities As we know the direct taxes are progressive in
nature and therefore rich people are subjected to higher rates of taxation,
while poor people are exempted from direct tax obligation. Hence these
taxes help to reduce inequalities in income
Demerits of Direct Taxes:-
• Unpopular: - Direct Taxes pinch to the tax payer because they have to
pay them directly out of their income or salaries they can not be shifted on
to others thus they are very much unpopular among tax payers and are
generally opposed by the tax payers.
• Inconvenient: These taxes .are also inconvenient in nature because the
tax payer has to submit the statement of his income along with the source of
income from which it is derived, which is generally subject to complications.
Moreover the payment of these taxes in lump sum is not as convenient to
the tax payers as the frequent payment of small amount of indirect taxes.
Hence these are said to be inconvenient to the tax payers .
• Possibility of injustice: - In practice it is difficult to asses the income of
all the classes accurately. Hence the direct taxes may not fall with equal
weight on all classes, Moreover the rates of direct taxes are arbitrarily fixed
by the govt. and they may not be determined on the basis of ability to pay.
• Evasion: - A direct tax is said to be a tax on honesty, it is not evaded only
when the tax payer is honest, otherwise it can be evaded through fraudulent
practices. Hence it is found that it can be evaded if the taxpayer decides to
become dishonest.
• Discourages Saving & investment: – Direct Taxes adversely affect
saving & taxes when people know that with increase in income & wealth
they will have to pay a large portion of their income in the form of taxes.
They all be reluctant to save & invest more this way direct taxes adversely
affect the will to work save & invest.
• Narrow in Scope: - Direct taxes or generally imposed on rich people low
income group cannot be approached through these taxes. In this way direct
taxes have their limited applicability .

INDIRECT TAXES:-
The tax which is initially imposed on one person and paid by another. In
case of indirect taxes impact and incidence fall on 2 different people for eg-
custom duty Sale Tax, Vat, etc.
Merits of Indirect Taxes:-
• Connivance :- Indirect Taxes are more convenient than direct taxes they
are paid in small amount and at some intervals. they are generally included
in price of the commodity & hence not much burden is felt by tax payer.
• Wide coverage :- These taxes reach to the all income groups low, middle,
high they are imposed on all type of commodities thus they have a wide
coverage & every consumer pays to the state. Ex-checker acc. to his ability
to pay thus they are equitable also to some extent.
• Elastic: - Indirect taxes are also elastic in nature the govt. Can reduce or
increase the rate of taxes, acc. to the requirements. The govt. can obtain
adequate tax revenue by increasing tax rate on those commodities which
are highly in demand & they have inelastic demand however, this will go
against common of equality .
• No evasion :- Indirect Taxes are difficult to be evaded as they are in
included in price of the commodity as a person can evade an indirect taxes
only when he decides not to purchase a taxed commodity
• Diversity : - Indirect Taxes satisfy the canon of diversity. They can be
imposed on verity of commodities and services. Thus govt. can earn
continuous and sufficient revenue from indirect taxes
• Direct the consumption of commodities :- Indirect taxes check the
consumption of harmful goods like wine tobacco & other such substances.
The state imposes heavy duties on such articles of consumption which are
injurious to health & efficiency of people as a result, their price rise &
consumption is reduced.

De-merits of indirect Taxes :-

• Regressive & unjust :- Indirect Taxes on necessities, which are
consumed by poor are regressive in nature. The rich & poor are required to
pay the same amount of tax on such commodities like matchbox, soap,
toothpaste, blades etc. but the burden is heavy on poor than on the rich,
thus they do not satisfy the canon of equity.
• Inflationary Impact :- Another demerit of indirect taxes is that they feed
inflation. Imposition of these taxes tends to raise the price of commodities
there by leading to higher cost to higher wages and again to higher prices,
thus price wage cost spiral sets in the economy.
• Uneconomical :- These taxes are uneconomical because the cost of
collection is very high the state has to appoint many tax collectors to check
the accounts and stock of producer, wholesalers & retailers in order to find
out whether they are paying taxes or not.
• Uncertain: - The Revenue from indirect taxes is uncertain because it is
not possible to estimate accurately the effect of such taxes on demand for
products. When the commodity is taxed its market price rises which results
in lower demand so it is quite difficult to anticipate the income from indirect
taxes.
• Discourages Saving: - Indirect Taxes discourage saving as they are
included in price so people will spend more on consumption expenditure,
hence saving reduces.
• Lack of civic consciousness: - A person who purchase a commodity
does not know that he is paying a tax to government in price of commodity,
therefore such taxes do not inculcate civic consciousness among majority of
tax payers who are ignorant of the fact that they are contributing something
the state treasury .

Difference between Direct & indirect taxes

Sl. Basis Direct Indirect

1 Meaning Direct Taxes are The tax which is
those under which initially imposed on
burden falls on the one person and paid
same person on by another. In case of
whom it is imposed, indirect taxes impact
i.e. impact and and incidence fall on 2
incidence falls on the different people
same person
2 Shifting of tax The can't be shifted They can be shifted
3 Impact &incidence They fall on the same It falls on two
person different people.
4 Civic consciousness It inculcates civic It does not inculcate
consciousness civic consciousness
5 Income & expenditure They are imposed on They are imposed on
income of the expenditure of tax
taxpayer payer
6 Nature of Tax They are compulsory They are not
in nature compulsory.
7 Examples Wealth tax , income Sales Tax, VAT, custom
tax & Property tax duty etc.
etc.

Canons of Taxation / Principles of Taxation / Characteristics of good

tax system :
A good tax system should follow certain principles which become its
characteristics thus a good tax system is based on certain principles which
are known as canons of taxation. Adam Smith was probably the first
economist who stated the general principles of taxation or rules of taxation.
They are even now considered as the Characteristics of taxation of good tax
system. According to Adam Smith father of economics there are 4 main
cannons of taxation which are as fallows
• Canon of Equality: - The cannon of equality equity or justice is most
important cannon of taxation. It means that every person should pay tax
according to his ability and not the same amount. it also means that every
body should not pay at the same rate rather every tax payer should pay the
tax in proportion to his income. The rich should pay more than the poor
whose income is less.
• Canon of Certainty : - Acc to smith there should be certainty in taxation
because uncertainty breeds corruption. The certainty aspects of a tax are
• Certainty of effective incidence i.e. who shall bear the tax burden.
• Certainty of tax amount payable in a certain time period
• Certainty of Revenue to the government how much govt. shall have
estimated collection of revenue during a given time period.
3. Canon of economy -: every tax should satisfy the canon of economy in
two ways
• It should be economical for the state to collect it
• It should be economical for the tax payer it means he should have
sufficient money left with him after paying the tax
[Link] of convenience: - According to Adam Smith every tax ought to be
levied at the time or in the manner in which it is more likely to be
convenient for the contributor to pay it .it implies that taxes should be
imposed in such a manner and at the time which is the most convenient for
the tax payer, e.g. the best time for the collection of land revenue is the time
of harvest.
Some other writer like Bastable added a few more canons of taxation to the
Adam Smith's four canons of Taxation these are
• Canon of productivity: - The productivity of a tax may be observed in
two easy ,in the first place ,a tax must yield a sufficient revenue for the
maintenance of the government. Secondly, the taxes should obstruct and
discourage production in the short as well as in the long run.
• Canon of Elasticity: Taxation should be elastic in nature this canon
implied that the yields of the taxes may be increased or decreased
according to the changing needs of the govt. The govt. resources can be
raised in emergencies like war floods droughts etc quickly only when the
tax system is elastic. Taxes on property and commodities are not so elastic
as income tax .
• Canon of Simplicity :- this canon suggest that tax system should be
easily understandable to tax payer i.e its nature, its aim, time of payment,
methods and basis of estimation should all be easily followed by the each
tax payer. However it is not very easy to observe this canon in the modern
tax system, which has become quite complex in nature.
• Canon of expediency : - Acc to this cannon a tax should be based on
sound principles so that it requires no justification from the side of
government. the possibility of imposition of taxes should be taken from
different angles, i.e. its reaction upon tax payers .some times it may be
desirable and may have most of the characteristics of a good tax system but
the govt. may not find it expedient to impose it,e.g. progressive agriculture
income tax is very much desirable in India, but it has not been imposed so
far in the manner it should have been imposed.
• Canon of diversity: - There should be variety of taxes a single tax.
Would neither meet the revenue requirement of state nor satisfy the canon
of equity thus there should be a variety of taxes so that all citizens should
contribute towards state revenue acc to their ability to pay.
• Canon of co-ordination : In a democratic country taxes are imposed by
central, state and local governments. It is therefore very much desirable
that there is vo-ordination between different taxes that are imposed by
different taxing authorities. it is very much needed considering the interest
of tax payer and the govt. both .

Main Sources of Revenue of central government.

Tax Revenue
• Income Tax(on income of the individual as well as joint Hindu families)
• Corporation Tax (on income of the companies both domestic and foreign
companies operating in India )
• Interest Tax (on the gross interest income of the financial institutions like
Bank)
• Expenditure Tax(expenditure incurred in luxury hotels and restaurants)
• Wealth Tax(total wealth of individuals and Hindu undivided families)
• Custom Duty.(import and export duty)
• Central excusive Duty.(duties on industrial products)
• Service Tax.(on services provided by hotels, telephones, port services
etc.)
2. Not Tax Revenue
(i) Interest received(on loans given by central govt. to other governments.)
(ii) Dividends & Profits
• Barrowing both from internal & extra source.
• Income from Railways
• Post & Telegram
• Commercial & non-commercial under
• Grants in Aid(from foreign countries as well as from international
organizations)

Sources of Revenue of State government

Tax Revenue.
• Land Revenue
• Tax on agriculture resources.
• Estate duty.
• Excise duty on liquors, OPM and other nonce
• Motor Vehicle Tax
• Entertainment Tax
• Electric city Duties
• Taxes on profession,
• Toll Tax
• Taxes on income
• Non Tax Revenue
• Borrowing within country and loans from govt. of India .
• Incomes from govt. undertaking, owned by State govt.
• Royalties from mines, forest, etc.
• Grant in Aid from central govt.
• Interest received.
• Dividends from public sector undertaking
• Administrative receipts
VAT :-
The value added Tax is a Tax on the Value added to a commodity or service
at each stage from production to retail stage
MOD VAT;-
The modified value added scheme allows the manufacturer to obtain instant
and complete reinvestment of the excise duty paid on the components of the
commodity.
Specific Tax :-
Taxes which are levied on the basis of specific qualities or attributes such as
Weight, size, volume etc are called specific taxes.
Ad. Valorem Tax :-
Taxes which are imposed. Acc to the value of commodity are known as
advalorem taxes. For eg. - import duty.
CEN VAT :-
Central Value added Tax was introduced in 2000-2001 and 20001 2002
budgets by replacing. The 3 advalorem rates with a single rate of 16%
Impact of a Tax :- The impact of a tax is upon the person who pays it in the
first instance in other words the person who pays the tax to govt. in first
instance bears its impact.
Shifting of a Tax :-
The process of passing on the money burden of a tax to another person is
called shifting of a tax.
Incidence of a Tax :-
It refers to the money of tax on the person who ultimately pays it. In the
words of Dalton. The incidence of a tax is upon those who bear the direct
money burden of tax.

Difference between impact and incidence

Impact of Tax Incidence of Tax

1. It refers to the initial burden of It refers to the ultimate burden of a
the tax tax

2. It is upon the person who pays it It is felt by the person who actually
in the first instance bears the burden of tax.

3. It can be easily shifted. It cannot be shifted

Theories of Taxation:

The economists have put forward many theories or principles of taxation

at different times to guide the state as to how justice or equity in taxation
can be achieved. The main theories or principles in brief, are:

(i) Benefit Theory:

According to this theory, the state should levy taxes on individuals

according to the benefit conferred on them. The more benefits a person
derives from the activities of the state, the more he should pay to the
government. This principle has been subjected to severe criticism on the
following grounds:

Firstly, If the state maintains a certain connection between the benefits

conferred and the benefits derived. It will be against the basic principle of
the tax. A tax, as we know, is compulsory contribution made to the public
authorities to meet the expenses of the government and the provisions of
general benefit. There is no direct quid pro quo in the case of a tax.

Secondly, most of the expenditure incurred by the slate is for the general
benefit of its citizens, It is not possible to estimate the benefit enjoyed by a
particular individual every year.
Thirdly, if we apply this principle in practice, then the poor will have to pay
the heaviest taxes, because they benefit more from the services of the state.
If we get more from the poor by way of taxes, it is against the principle of
justice?

(ii) The Cost of Service Theory:

Some economists were of the opinion that if the state charges actual cost of
the service rendered from the people, it will satisfy the idea of equity or
justice in taxation. The cost of service principle can no doubt be applied to
some extent in those cases where the services are rendered out of prices
and are a bit easy to determine, e.g., postal, railway services, supply of
electricity, etc., etc. But most of the expenditure incurred by the state
cannot be fixed for each individual because it cannot be exactly determined.
For instance, how can we measure the cost of service of the police, armed
forces, judiciary, etc., to different individuals? Dalton has also rejected this
theory on the ground that there s no quid pro qua in a tax.

(iii) Ability to Pay Theory:

The most popular and commonly accepted principle of equity or justice in

taxation is that citizens of a country should pay taxes to the government in
accordance with their ability to pay. It appears very reasonable and just that
taxes should be levied on the basis of the taxable capacity of an individual.
For instance, if the taxable capacity of a person A is greater than the person
B, the former should be asked to pay more taxes than the latter.

It seems that if the taxes are levied on this principle as stated above, then
justice can be achieved. But our difficulties do not end here. The fact is that
when we put this theory in practice, our difficulties actually begin. The
trouble arises with the definition of ability to pay. The economists are not
unanimous as to what should be the exact measure of a person's ability or
faculty to pay. The main view points advanced in this connection are as
follows:

(a) Ownership of Property: Some economists are of the opinion that

ownership of the property is a very good basis of measuring one's ability to
pay. This idea is out rightly rejected on the ground that if a persons earns a
large income but does not spend on buying any property, he will then
escape taxation. On the other hand, another person earning income buys
property, he will be subjected to taxation. Is this not absurd and
unjustifiable that a person, earning large income is exempted from taxes
and another person with small income is taxed?

(b) Tax on the Basis of Expenditure: It is also asserted by some

economists that the ability or faculty to pay tax should be judged by the
expenditure which a person incurs. The greater the expenditure, the higher
should be the tax and vice versa. The viewpoint is unsound and unfair in
every respect. A person having a large family to support has to spend more
than a person having a small family. If we make expenditure. as the test of
one's ability to pay, the former person who is already burdened with many
dependents will have to' pay more taxes than the latter who has a small
family. So this is unjustifiable.

(c) Income as the Basics: Most of the economists are of the opinion that
income should be the basis of measuring a man's ability to pay. It appears
very just and fair that if the income of a person is greater than that of
another, the former should be asked to pay more towards the support of the
government than the latter. That is why in the modern tax system of the
countries of the world, income has been accepted as the best test for
measuring the ability to pay of a person.

Proportionate Principle:

In order to satisfy the idea of justice in taxation, J. S. Mill and some other
classical economists have suggested the principle of proportionate in
taxation. These economists were of the opinion that if taxes are levied in
proportion to the incomes of the individuals, it will extract equal sacrifice.
The modern economists, however, differ with this view. They assert that
when income increases, the marginal utility of income decreases. The
equality of sacrifice can only be achieved if the persons with high incomes
are taxed at higher rates and those with low income at lower rates. They
favor progressive system of taxation, in all modern tax systems.

Essentials/Features/Characteristics of a Good Tax System:

After discussing the principles of taxation, it is now easy for us to sum up
the essentials of a good tax system. They, in brief, are as follows:

First, a good tax system should lead to fair and equal distribution of wealth
in the community.

Second, it should be composed in such a way that it yields sufficient

revenue to the government.

Third, the cost on collection of taxes should not be excessive.

Fourth, the burden of taxes should be distributed in proportion to the

ability of the tax-payer, i.e., it should be progressive in character.

Fifth, taxes should he levied at such a time or in the manner which is most
likely to be convenient for the tax-payer to pay it.

Sixth, tax system should be fairly elastic.

Seventh, there should be certainty with regard to the time and the amount
to be paid to the government.

Eighth, the system of taxation should be fairly simple, It should also be

easy to administer.
 Lecture Three
Incidence, Impact and Taxable Capacity

Impact and Incidence of Taxation:

Definition of Incidence of Tax:

One of the very important subjects of taxation is the problem of incidence
of a tax. By incidence of taxation is meant final money burden of a tax or
final resting place of a tax. It is the desire of every government that it
should secure justice in taxation, but if it does not know as to who
ultimately bears money burden of a tax or out of whose packet money is
received, it cannot achieve equality in taxation. If government knows who
pays tax, it can evolve an equitable tax system. It can easily tap important
sources of taxation and thus can collect large amount of money without
adversely affecting economic and social life of the citizens of the country.

Definition of Impact of Tax:

Impact of a tax is on person from whom government collects money in first
instance. While incidence of a tax is on person who finally bears burden of a
tax

Explanation:
To make it more clear, we take an example. Suppose government levies a
tax on electric goods in Kenya. Tax will be paid to Government in first
instance by manufacturers of electric goods. Impact of tax is, therefore, on
them. If manufacturers of electric goods industries add tax to price and
succeed in selling goods at higher prices of electric goods to consumers,
burden of tax is thus shifted on to consumers.

Incidence is Different From Shifting:

Incidence is final resting place of a tax while shifting is process of

transferring money burden of tax to someone else. Shifting finally ends in
incidence. When a person on whom tax is levied tries to shift tax on to the
other, he may succeed in shifting tax completely, partly, or may not succeed
at all. Shifting of tax can take place in two directions, forward and
backward. If tax is shifted, from seller to consumer, it is a case of
forwarding shifting.
Backward shifting takes place when consumers do not purchase
commodities at increased prices. Sellers are! then forced to cut down prices
and bear burden of tax themselves. Backward shifting is thus performed by
buyers.

Incidence and Effect of a Tax:

Before we proceed further it seems necessary that we should distinguish

the concept of incidence from effect. As stated earlier incidence is direct
money burden of a tax. Effect of taxation is repercussions or consequences!
of imposition of a tax on individuals and on community in general.
Taxable Capacity:

The concept of taxable capacity has been defined differently by different

economists. In the words of Sir Josiah Stamp:

"Taxable capacity is that maximum amount which the community is in a

position to bear towards the expenses of public authorities without having a
really unhappy and! down-trodden existence and without dislocating the
economic, organization too much".

According to Findlay Shiraz:

"It is the optimum tax ability of a nation, the maximum amount of taxation
that can be raised and spent on the economic welfare in that community".

Dalton calls it a dim and "contused conception". He writes in his book

"Principles of Public Finance":

"Absolute taxable capacity is a myth and should be banished from all

serious discussions of public finance".

For the various definitions of taxable capacity given by eminent writers on

Public Finance, we gather that by taxable capacity is meant the maximum
amount which a nation can contribute towards the support of the
government without inflicting damage on the power and will to produce.
The amount of tax burden which the citizens of a country are ready to bear
is not rigidly fixed. It can increase or decrease with a change in the
distribution of wealth, the size of population, method of taxation, etc. etc.

In other words, we can say that the limit of taxable capacity is a relative and
not an absolute quantity.

Factors Affecting Taxable Capacity:

The main factors which determine the taxable capacity of a nation are:

(i) The size of population: Taxable capacity is very much affected by the
increase in national income and by the rate of growth in population. If the
increase in national income is greater than the growth in population, the
par capita income goes up. The taxable capacity of the individuals rises. If
the rate of growth of population is higher than the national income, the
taxable capacity decreases.

(ii) The distribution of national income: Taxable capacity is also

influenced by the distribution of national income within a country. If there is
unequal distribution of wealth in the country, the taxable capacity of the
nation will be high, but if the income is equally distributed, then the taxable
capacity will be low. A man earning an income of $50,000 a month is able to
pay more to the government than thirty persons earning $300 per month.

(iii) Character of taxation: If taxes are devised wisely, then they give less
resentment from people and bring forth a large yield.

(iv) Purpose of taxation: Purpose of taxation has a direct bearing on

taxable capacity of a nation. If citizens of country are satisfied with purpose.
of taxation i.e., the increase in welfare of people, then they show greater
willingness to pay taxes to government. Whereas, if they find that revenue
will be spent for unproductive purposes, they hesitate to pay taxes.

We conclude, therefore, that if state spends revenue for purposes such as

education, sanitation, fighting for famine, diseases, etc., then taxable
capacity of nation expands to its utmost and if revenue is spent for
unproductive purpose like war, then taxable capacity shrinks.
(v) Psychological factor: Psychological factor, is a very important factor in
determining taxable capacity of a nation. If people are satisfied that
government is doing its utmost to raise standard of living of masses and in
maintaining prestige of country, then they try to sacrifice their lives what to
say of money for the government. A simple approach to patriotism brings
forth tons of gold.

(vi) Standard of living of people: If standard of living of people is high,

they work more efficiently so that they may enjoy a still better standard of
living. When they work enthusiastically, they receive higher wages from
their employers. Taxable capacity tends to increase then.

(vii) Effect of inflation: If country is in grip of inflation, purchasing power

of people is reduced, taxable capacity of nation shrinks considerably. But if
value of money is high and country is not faced with unemployment, then
taxable capacity of people is quite high.

Conclusion:

We have discussed above various factor on which taxable capacity of a

nation depends. We cannot single out any factor and say that taxable
capacity is determined solely by this factor alone. The fact is that various
factors influence taxable capacity and we have to take them all into
consideration while judging maximum amount which citizens of a country
can pay. We cannot deny this fact that it is quite difficult to measure taxable
capacity. But this does not mean we should not make an attempt because it
is beset with many difficulties.

According to Findly Shiraz:

"A road leading to an important centre has often many crossings, signposts,
danger signals, but this does not lessen its value to cautions sojourner".

Diffusion Theory of Taxation:

Definition and Explanation:

According to diffusion theory of taxation, under perfect competition,

when a tax is levied, it gets automatically equitably diffused or absorbed
throughout the community. Advocates of this theory, describe that:
"When a tax is imposed on a commodity by state, it passes on to consumers
automatically. Every individual bears burden of tax according to his ability
to bear it".

For instance, a specific tax is imposed on say, cloth. Manufacturer raises

prices of commodity by the amount of tax. Consumers buy commodity
according to their capacity and thus share burden of tax. In the words of
Mansfield:

"It is true that a tax laid on any place is like a pebble falling into a lake and
making circles till one circle produces and gives motion to another".

This quotation has been given to explain to readers that just as a pebble
gets diffused in a lake, similarly a tax imposed on a commodity is also
absorbed and its burden is felt equally among various sections of
community.
Assumptions:

Advocates of this theory assume perfect competition in the market but in

world of reality, it is imperfect competition which prevails.

If tax gets automatically diffused through the community, then most of

worries of finance minister will be over. He will simply impose tax and
collect money from people without worrying about final resting place of a
tax. In actual practice we find that taxes do not get distributed equally.
Some taxes remain where they are imposed first and some are partly or
wholly shifted on to me consumers. Let us consider now some important
taxes and see who ultimately pays it.
Criticism:
Diffusion theory of taxation has never gained any importance in the
world of reality. It has never been seen that a tax gets automatically
equitably distributed among people. It is true that in some taxes, diffusion
or absorption does take place but that too is not throughout the community.

Accordingly, the reason for rejecting theory of taxation is that there are few
taxes like income tax, inheritance tax, toll tax in which there is no
absorption at all. How can this theory state that tax burden is automatically
spread throughout the community?
Incidence of a Tax on Commodities:
In considering incidence of a tax on commodities, we must take into account
of the following factors:

(i) Elasticity of demand and supply: If the demand for a commodity is

inelastic, then incidence of tax will be on purchasers. It is because seller
knows that if price is raised by full amount of tax, purchasers will not curtail
their demands. So he shifts the tax entirely on to the consumers. If demand
for a commodity is perfectly elastic, then incidence of tax is on sellers
because seller is aware of fact that if price is raised even by a slight
amount, purchasers will drop consumption.

Similarly, when supply of a commodity is perfectly elastic, incidence of tax

falls on to the consumers. This is because of fact that seller is in a position
to curtail production and when seller finds that he is not getting profit from
taxed commodity, he stops production and thus dictates terms. In case of
perfect inelastic supply, burden of tax finally rests on seller because he is
not in a position to raise price of commodity by reducing supply of it.

(ii) Availability of substitutes: If a taxed commodity has a number of

untaxed substitutes, then incidence of tax will be on seller. For example, if
government imposes tax on tea and coco remains unaffected from tax, then
seller of tea will not be able to raise its price because he knows that if he
raises price of tea he will lose customers, so he bears the tax himself. If
substitutes are not perfect, then seller can shift the tax on to the
consumers.

(iii) Degree of competition: If commodities on which tax is levied are

facing stiff competition in market and tax is very small, then it may not be
passed on to purchaser due to fear of losing market. Incidence of tax in that
case will be on seller.

(iv) Laws of return: If a commodity is produced under conditions of

diminishing returns, then prices may not rise by an equal amount of tax but
by an amount less than tax. Under conditions of increasing returns, it may
rise by more than the amount of tax. Under conditions of constant return,
price rises by full amount of tax.

(v) Incidence of tax on income: Economists are of opinion that incidence

of tax on income cannot ordinarily be shifted in form of addition to prices. It
is generally paid by person on whom it is levied. Businessmen, however,
differ with this view. They are of the view that burden of income tax can be
shifted on to the consumers in shape of higher prices.

When a trader endeavors to ascertain his costs with a view to fix prices, he
often takes into account the amount of income tax he will have to pay.

If market conditions permit, he fixes price at such a level as would yield to

him maximum net income that he desires to obtain. Economists here point
out that businessmen cannot raise price of commodity by full amount of tax
because they are faced with stiff local and foreign competition for their
products. If they shift the burden of tax on to purchasers, other producers
will undersell and capture the whole of market.

(vi) Incidence of tax on monopoly: If a tax is levied on profits of a

monopolist, he will not be able to pass tax on to purchasers of his products.
It is due to fact that he has already fixed price which yield him maximum
net profit. If he raises price now, demand far commodity will curtail and so
his profit is reduced.

(vii) Incidence of tax on buildings: In case of buildings, there are two

main parties involved, owner of house or shop and occupier. When a tax is
levied on houses, owner tries to shift tax forward to occupier. Whether he
will be able to shift tax or not depends upon elasticity of demand for houses
in that locality. If demand for houses 'is inelastic, then tax in the first stage
will be shifted backward to occupier.

In long period, however, position will be different. When owners of houses

bear burden of tax, persons who are desirous to construct houses will be
discouraged and thus will not construct houses. After sometimes, with
increase in population, demand for houses will increase.

Owners of houses will then be in a position to shift burden of tax on to

occupiers. If a house is given on a long term lease, incidence of tax will be
on owner. In case of a tax on shops, owner will shift it forward to occupier, if
he is not faced with stiff competition, he will try to shift it on to consumers
by raising price of commodities.

(viii) Tax on imports and exports: Tax on imports is shifted forward to

home consumers. But if demand for commodity is highly elastic and its
supply is inelastic, then tax can be shifted backward to foreign producer.
As regards tax on exports, incidence is on exporters. It is not possible
ordinarily for an exporter to influence world price. If he raises price of his
commodities by full amount of tax, his goods will not be sold in market. In
order to sell goods, he bears incidence of tax himself.

If, however, he is a monopolist and demand for his commodity is inelastic,

then he can shift tax forward to consumers in other countries.
 Lecture Four

TYPES OF TAXES IN KENYA

1. Income Tax

Income tax is a direct tax charged upon all the income of a person, whether
resident or non-resident, which accrued in or was derived from Kenya.

Income Tax is imposed on;

 Business income from any trade or profession
 Employment income
 Rent income
 Investment income
 Income from services rendered among others
 Pensions among others

There are different methods of collecting income tax from companies &
partnerships, based on their sources of income.

These methods include:

a. Corporation Tax

This is a form of Income Tax that is levied on corporate bodies such as

Limited companies, Trusts, and Co ? operatives, on their annual income.

Companies that are based outside Kenya but operate in Kenya or have a
branch in Kenya pay Corporation Tax on income accrued within Kenya only.
Do partnerships pay corporation tax?

b. Pay As You Earn (PAYE)

This is a method of collecting tax at source from individuals in gainful

employment.

Companies and Partnerships with employees are required to deduct tax

according to the prevailing tax rates from their employees? salaries or
wages on each payday for a month and remit the same to KRA on or before
the 9th of the following month.

c. Withholding Tax (WHT)

This is a tax that is deductible from certain classes of income at the point of
making a payment, to non-employees.
WHT is deducted at source from the following sources of income:
 Interest
 Dividends
 Royalties
 Management or professional fees (including consultancy, agency or
contractual fees)
 Commissions
 Pensions
 Rent received by non-residents
 Other payments specified

Companies and partnerships making the payment, are responsible for

deducting and remitting the tax to the Commissioner of Domestic Taxes.

d. Advance Tax

This is a tax paid in advance before a public service vehicle or a commercial

vehicle goes for the annual inspection.

e. Installment Tax

Installment tax is paid by persons who have tax payable for any year that
amounts to Kshs. 40,000 and above.

2. Rental Income Tax

This is a tax charged on rental income received from renting out property.
Taxation of rental income depends on how the rented property was used for
residential or commercial purposes.

Companies and Partnerships that rent out property to other persons for
either residential or commercial use are required to pay income tax on rent
received

To facilitate compliance, KRA appoints agents to withhold and pay, a

percentage of the gross rent as tax. These agents can be verified via the
agent checker on iTax.

3. Value Added Tax (VAT)

Value Added Tax is charged on supply of taxable goods or services made or

provided in Kenya and on importation of taxable goods or services into
Kenya.
While companies & partnerships can voluntarily register for VAT they MUST
register if their annual revenue exceeds Kshs. 5,000, 000.

To facilitate compliance, KRA appoints agents to withhold and pay, VAT on

supplies made. These agents can be verified via the agent checker on iTax.

4. Excise Duty

This is a duty of excise imposed on;

 goods manufactured in Kenya, or;
 imported into Kenya and specified in the 1st schedule to Excise Duty
Act, 2015.

Companies and Partnerships dealing in excisable good and services are

required to pay excise duty.

The List and types of Excisable goods and services are listed in the 5th
Schedule as read together with Section 117 (1) (d) of the Customs and
Excise Act, CAP 472 Laws of Kenya.

They includes;
 Mineral water
 Juices, soft drinks
 Cosmetics and Preparations for use on hair
 Other beer made from malt
 Opaque beer
 Mobile cellular phone services
 Fees charged for money transfer among others

5. Capital Gains Tax (CGT)

This is a form of income tax which is charged on a net gain that a business
makes after sale of land or building.

What is Capital Gains Tax?

Capital gains tax is a tax imposed on capital gains or the profits that an
individual makes from selling assets. The tax is only imposed once the asset
has been converted into cash, and not when it’s still in the hands of an
investor.
For example, assume that an individual owns company shares, which
increase in value each year. In this case, no capital gains tax will be levied
just because the shares are appreciating. The only time the capital gains tax
will be imposed is when the individual decides to sell the shares for a price
higher than their purchase price.
The Basics

In the majority of countries, tax regulations stipulate that capital gain taxes
can be levied on investors’ gains. In Canada, for instance, the law requires
individuals to pay at least half of their marginal tax rate on profits earned
from asset disposal. Similarly, in the United States, both residents and
companies incur capital gain taxes on their yearly net capital gains.
Ideally, a capital gain tax is levied on any person or firm that decides to sell
an asset for profit. The only exception is for day traders, who engage in the
buying and selling of assets to make a living. As for the day traders, the
profits they make are taxed on the basis of their business revenue rather
than capital gains. It’s also important to note that capital gain taxes are
levied on different types of assets, whether they are stocks, bonds, or real
estate property.

Short-term vs. Long-term Capital Gains

One thing that firm owners need to keep in mind is that assets are not taxed
equally, especially when it comes to investment incomes. The amount of tax
levied will depend on the asset’s holding period.
Essentially, there are two kinds of profits that a company can make when it
disposes of an asset: long-term capital and short-term gains.
Long-term capital gains arise when investments or other assets are held for
a period of more than 12 months. In contrast, short-term gains are realized
on investments held for less than 12 months. Take the example of a
shareholder who buys 150 shares of stock at a price of $20 per share. Six
months down the line, he decides to sell them at a price of $25 per share;
hence making a profit of $750. The profit is classified under short-term
capital gains. Differentiating between these capital gains is crucial because
the two are taxed differently.
Reducing Capital Gains Taxes

Regardless of the kind of asset that individual plans to sell, there are a few
methods used to reduce the capital gains tax incurred. They include:

1. Waiting longer than one year before selling

As already explained, once a company sells an asset, it can make long-term

or short-term capital gains. One of the benefits of capital gains that fall
under the long-term status is that they attract lower capital gains tax rates.
As such, one of the ways to reduce the tax that one is liable for is to hold
assets for a longer period. Here is a breakdown of how capital gains tax is
levied:

 Marginal rates ranging between 10% and 15% pay a rate of 0%

  Marginal rates that range from 25% and 28% to 35% attract a tax of
15%

 Marginal rates of 39.6% pay a capital gains tax of 20%

For example, if an individual in the 28% tax bracket decides to sell stock
that amounts to a capital gain of $5,000, the difference in tax based on
short- and long-term gain is:
Short-term gain taxed at 28%: $5,000*0.28 = $1,400
Long-term gain taxed at 15%: $5,000*0.15 = $750
2. Sell when your income is low

As seen in the outline above, the long-term capital gains rate is determined
by one’s marginal tax rate, which is then dependent on an
individual’s income. That said, disposing of long-term capital gain assets
during “lean” years can help reduce the capital gains tax.
Situations that may cause a decline in an individual’s income include
approaching retirement period, quitting, or loss of employment. Selling
assets at such times can minimize the amount of capital gains tax levied.
3. Timing capital losses with capital gains

In any given period, capital gains are used to offset capital losses. Let’s
assume that an individual owns two types of stocks: A and B. When he sells
stock A, he makes a profit of $60, but when he sells stock B, he makes a loss
of $30. His net capital gain is the difference between his capital gain and
loss: $30.
By using capital losses in the years where he made capital gains, an
individual can lower his capital gains tax significantly. Even though
individuals are required to report all their capital gains, the tax to be levied
is computed on the net capital gain.
Final Word

A capital gain occurs when the sales price received from disposing of an
asset is higher than its purchase price. A capital gains tax is that tax
imposed on the profits made from such sales. However, there are a few
tricks that can be employed to lower the amount of capital gains tax
imposed. They include holding assets for a longer period before selling
them, disposing of assets when their income is low, and using capital losses
to offset the gains.

4.2. Arguments for taxing capital gains

5.2.1. In policy terms, there are many reasons why capital gains might be
taxed, and not all of them will be directly relevant to transfers of extractive
assets or even other corporate assets. Reasons commonly given for taxing
capital gains when realized include the following:
 (i) The need for base broadening – with a trend to wider tax bases and
lower rates among many countries. The benefits from ownership of property
and other forms of capital may not otherwise be as comprehensively taxed
as income and consumption and expanding the tax base in this direction
may also have lower economic costs than a rise in tax rates on income
items;5
(ii) The concern that if there is no CGT (or even taxation at a lower rate),
taxpayers would rather acquire assets generating capital gains, because of
the difference in tax treatment between ordinary income and capital gains,
thus distorting economic decisions. This lead to a lack of “horizontal equity”
between two persons earning the same amounts, one through a capital gain
and one through ordinary income, such as wages or business profits. In fact,
a CGT may reduce an incentive to invest in those most likely to produce
capital gains.6 Without CGT, there is a lack of neutrality in the system that
prefers capital returns over normal income and creates incentives towards
conversion of normal income into capital gains, or encourages converting,
or appearing to convert, the former into the latter. Horizontal equity
requires that individuals in similar economic circumstances should bear a
similar tax burden irrespective of the form the accretion of economic
benefits takes. In other words, taxpayers should bear similar tax burdens,
irrespective of whether their income is received in the form of wages, or
capital gains. In this context, the exclusion of capital gains from the income
tax base fundamentally undermines the horizontal equity of the tax system;
(iii) The concessionary treatment of capital gains as compared to income
gains can also lead to speculation and inflation of preferred classes of
investments (such as the housing sector). This leads to inefficient
allocations of resources, as well as the waste of human capital in re-
characterizing income as capital gains and in combatting such attempts.
The application of scarce resources to tax planning and tax avoidance is a
dead-weight loss to society;
(iv) The richest persons (including corporates) will be most likely to make
significant capital gains. To tax capital gains reflects their greater ability to
pay tax and addresses the conversion of income into capital. Not taxing
capital gains results in a lack of horizontal equity which arises because one
taxpayer is likely to have proportionately more capital returns, while the
other earning the same amount is likely to rely more on normal income.
Vertical equity requires that taxpayers with greater ability to pay taxes
should bear a greater burden of taxation. It is commonly accepted that
capital gains accrue disproportionately to higher income individuals. Thus,
including capital gains in taxable income contributes to the progressivity of
the income tax system, while enabling government to pursue other tax
policy objectives, premised on widening tax bases and reducing standard
tax rates7
(v) A comprehensive CGT represents a “safety net” that taxes economic
gains that would avoid taxation as normal income. It thus implements a
more comprehensive concept of taxable “income” than might apply on
normal concepts, such as in case law. In some countries, the law might in
fact already reflect this more comprehensive approach to “income tax”; and
(vi) Taxing such gains will speed up the point when income is returned.
4.3. Arguments against taxing capital gains
5.3.1. Reasons commonly given for not taxing such gains when made
include the following:
(i) A tax on capital gains inappropriately taxes illusory income, since a large
component of any “gain” is due to inflation for assets held over many years;
(ii) Not taxing capital gains may encourage investments by allowing them to
occur at a lower economic cost, which in turns creates jobs and encourages
economic growth;
(iii) A comprehensive CGT may be difficult to administer and the potential
savings and investment distortions and other efficiency implications that
may arise from a partial CGT is economically harmful;
(iv) The complexity (including difficulties in identifying all possible disposal
events) of many comprehensive CGT regimes, especially for developing
countries, with high compliance costs (for taxpayers) and to administer
them (for the revenue administration). One US Senatorstated in 2012 that:
“We must consider complexity. Experts tell us that about half the U.S. tax
code – more than 20,000 pages – exists solely to deal with capital gains.” ;
(v) Taxing business related capital gains is purely a timing issue. If gains are
taxed, the purchaser obtains a tax basis in the assets equal to the price
paid, which provides a tax deduction over time against the purchaser’s
future income. If the gain is not taxed, no such increased tax basis arises
and future income and taxes due are higher. The overall tax paid over time
is the same;
(vi) Capital gains taxes are in a sense “voluntary” taxes, unlike taxes on
ordinary income. Only when a taxpayer chooses to dispose of assets may tax
be payable in respect of those assets. Economic decisions as to disposal of
assets will therefore be influenced and potentially distorted by such a tax.
This arises since there will be an incentive to retain some investments, even
if more profitable or productive opportunities exist, with the result that the
economy loses the extra output that would have resulted from the
reallocation of capital occurring in the absence of the CGT. This is the so-
called “lock-in effect” of capital gains tax11 ;
(vii)Not taxing capital gains can keep a country competitive with other
countries that do not tax such gains, and create a competitive advantage
over those that do;
(viii) Economic double taxation arises if capital gains on the sale of shares
and other interests in entities directly or indirectly owning business assets
are taxed. The value of the shares and other interests reflects expected
future profits of the extractive activities and the future profits will be taxed
as they arise. That would also be the case if the business assets consist of
extractive licences, mining and petroleum extractive assets;
(ix) The double taxation argument may not be valid in the case of
speculative profits realized on the disposal of those shares and interests
which may not reflect actual profits to be earned by the extractive activities.
Governments should also be cautious of the risk that the tax base of the
company or entity holding the extractive assets could run the risk of being
eroded. The latter may for example in some situations occur due to a debt
push down of the interest charges on loans acquired to fund the takeover of
the shares or interests by the buyer; and (x) Taxes on gains from sales of
investment assets are in effect a double-tax. The income earned to make the
investment was already subject to an income tax and thus taxing the income
from the investment, taxes the investor a second time.

6. Agency Revenue

This is a type of payment that KRA collects on behalf of various revenue

collection agencies in Kenya.
The two types of Agency Revenue include;
 Stamp Duty
 Betting and Pool Tax

a. Stamp Duty

Stamp duty is a tax charged on transfer of properties, shares and stock.

It is collected by the Ministry of Lands, which has seconded the function to

Kenya Revenue Authority (KRA).

b. Betting and Pool Tax

This is a tax charged on winnings from betting, gaming and lottery

activities.
Betting, gaming and lottery businesses are required to withhold as tax, and
pay to KRA, a percentage of the winnings being paid out to winners.