2.

2 Definition and purpose of Taxation

Taxation is often defined as the levying of compulsory contributions by public authorities, having the
jurisdiction to defray the cost of their activities. The money collected isused for the common good of the
citizenry, for the production of certain services, which are considered to be more efficiently provided by
the state rather than by individuals. E.g. maintenance of law and order at home, and defense against
external enemies.

2.2.1. Purpose of Taxation

The definition of taxation given above underlines the main purpose of taxation. That is to raise revenue
to defray the cost of services provided by the state. Other purposes of taxation are to reduce
inequalities arising from the distribution of wealth, to restrain certain types of consumption, to protect
home industries and to control certain aspects of the countrys economy. E.g. balance of payment,
employment, savings, investment and productivity. In addition, to the above, other purpose of taxation
could be summarized as follows.
1. Increased effective productivity of the nation.
2. Increase in the quantum of revenue collection.
3. Improvement in services of the government
4. Improve employment at all industry verticals
5. Induction of modern technology into the system
6. Rationalization of terms and conditions of the economic system.
7. Rationalization of employment terms and conditions.

2.3 Attributes of a Good Tax System

Adam Smith (1778) one time British economist annunciated four attributes which he called
cannons of taxation (in his book The wealth of Nations). These principles are very significant and
they are as true today as in his days. They are:

Equity: The tax system should be fair to both tax officers and tax payers. The subject of every state
ought to contribute towards the support of the government as nearly as possible in proportion to
their respective abilities. Ability to pay refers to the economic resources under a persons control.

Certainty: The tax authorities should make all tax systems and mode of administration very clear
to the tax payer. In other words, tax payers should be made aware about the tax system being used.
They should also be aware about the obligation under the system. Similarly, the tax payer should
be aware of the benefit to be derived. Additionally, the time of payment, the manner of payment,
the amount to be paid, the place of payment as well as all rights and obligations under the tax laws
must be known to both the tax administrator and the tax payer, the tax system should be made very
convenient to the tax payer.
Convenience: Every tax ought to be levied at the time or in manner in which it is most likely to be
convenient for the contributor to pay it. The method of collecting the tax should be such that the
majority of tax payers would understand and routinely comply. The collection method should not
be made to overly intrude on tax payers privacy but should offer minimal opportunity for
noncompliance.

Economy: This implies that the tax revenue should always exceed the cost to be incurred in
generating the tax or its administration. Every tax ought to be so contrived as both to take and keep
out of the pockets of the people as little as possible over and above what it brings into the
consolidated fund. Apart from the above mentioned cannons of taxation, these are other attributes
that later come up to support those annunciated by Adam Smith. They are.

Simplicity: A major component of economic efficiency is the tax structures simplicity, that is what
it cost taxpayer to comply with tax policy. Elasticity: This means that a tax system should respond
automatically to changes in the tax payers wealth, population and other important variables.

Productivity: This principle emphasizes that the tax system ought to produce a high met yield of
revenue but not so high as to damage the source of that revenue.

2.4 Impact, Incidence and Taxable Capacity

i The impact of tax. This refers to the pinch of payment and this is on the person who pays the
tax initially. It is upon those who bear the first responsibilities of paying it to the tax authorities.

ii The incidence of tax: This means the ultimate economic burden represented by the tax. It is
the money burden which is on the person who finally pays the tax and who is unable to pass it on
to another The terms indicate the final resting place of the

tax.

Iii Taxable capacity: This is a countrys limit or capacity to accept and absorb taxation and this is
determined to a large extent by numerous factors which includes.

The countrys real wealth

The attitude of the population to taxation in general

The type of taxes levied

The possibilities of tax evasion

The level beyond which any increase in taxation might lead to a reduction in national income.
(e.g.the effect of tax incentives, wage demands, price increases).

2.5 Types of Tax System

We have three major systems of taxation, these are:

1. Progressive tax system: It is a system of taxation whereby those with higher income pay more,
whereas lower income earners pay less tax. In Nigeria, PAYE uses progressive tax system because
the graduated tax rate reflects.

2. Regressive Tax System: Under this system, the higher income earner pays proportionately lower
whilst the lower Income earners pays higher. Regressive tax systems are practiced in few
developed countries.

3. Proportional Tax System: It is a tax system whereby all persons pay a flat rate of tax irrespective
of the size of your income. Your tax payment is proportional to your income.

2.6 Kind of Taxes

These are many classifications by different authors as what should be the major kind of taxes. The
general acceptable classification is

a. Direct Tax

b. Indirect Tax

a. Direct Tax: This is a tax extracted directly from the person who will bear the burden of it. It is
tax directly collected from the income of the tax payer. It includes, poll tax, a general property tax
income tax. The administering authority of this kind of tax is the internal revenue services or
(Board of internal revenue).

Advantages of direct taxation

Incidence and yield are easy to determine

The tax payer knows with certainty what he is expected to pay

Yield increase automatically as wealth and population increases.

Direct taxes are in general progressive

Disadvantages of direct taxation

The Cost of administration is very high

The effect on incentive, enterprise and savings in the case of those with large incomes may be
considerable.

b. Indirect Tax

This is the tax levied indirectly .it is levied on commodities before they reach the final consumer,
but ultimately paid by the consumer as part of the market price. Here the impact and incidence are
of different persons. They are called indirect because the administering authorities which levy the
taxes on goods and services do not collect the taxes from the consumer but do so indirectly through
importer, manufactures or other intermediaries. The shifting or passing on of the liability is
effected by loading the tax element on the selling price of the commodities sold to the next person
in the commercial chain until it is finally borne by the consumer.

Advantages a Indirect Taxation

a. Payment and collection of the tax, are easy and convenient

b. In general, its yield is elastic

c. Evasion is very difficult

d. Restriction of harmful consumption,

Disadvantages of indirect taxation

a. They are often regressive

b. Revenue may be uncertain where the demand for the taxed good is elastic

c. Incidence is not easy to determine

d. They are not always equitable.

The above mentioned systems of taxation cannot be complete without references to the popular
tax theory knowas The faculty theory of Taxation.

This faculty theory of taxation seeks to establish the principle that tax payers should contribute
towards the revenue of the state in some direct relation to their capacity to do so. The theory is
simply that the rich should be taxed more heavily than the poor because their ability to pay is
greater.

2.8 Conceptual analysis of Value Added Tax (VAT)

The concept VAT (Value-Added Tax) has been given different definitions by different
authors and writers. According to Nworji as Quoted in (Chima 1996) Value-Added Tax
is defined as a consumption tax whereby the consumer is made to bear the tax
burden. The tax burden is passed from the manufacturer to wholesaler to retailer and
finally to the consumer who has been designed to bear it without complaints from the
above, it therefore means that the VAT can only be avoided by the consumer if he
avoids buying any of the vat able goods or services, that is an item on which VAT is
paid. Similarly, a vatable person is one who trades in vatable goods and services for a
consideration.
According to IMF survey, VAT can be defined as an indirect tax imposed on each sale
beginning at the start of the production and distribution cycle and culminating in the
sales to the consumer. It went further to create the
impression that it is the consumer that absorbs the VAT as
part of the sales prices, showing that VAT essentially is a
consumption tax collected, throughout the production
chain.

VAT is a more broadly based tax on consumer expenditure

which with a few exception, is levied in all goods and
services at the rate which vary from one country to another.
Okpe (2000) in his own definition, defined VAT as a multi
stage tax imposed on the value added to goods and services
as they proceed through various stages of production and
distribution and to services as they are rendered, which is
eventually borne by the final consumer but collected at each
stage of production and distribution chain. This definition,
brings out the three characteristics of value added tax,
which are
1. VAT is a consumer tax
2. VAT incidence is on the final consumer
3. VAT is a multi stage tax.

Jennings (1986( also describe VAT as a tax levied at each

stage which supplies changes hands. In the case of
manufactured items, this could be at the primary producer,
manufacturer, wholesaler and retailer stages. It is ultimately
borne by the consumer.

From the above definitions, of VAT by Jennings, he suggests

that there are intermediaries through which a produced
goods or services must pass before getting to the financial
consumer. At each stage the goods pass from one person to
another, a value is added to it. It is this value that is being
taxed and borne at last by the final consumer. The above
mentioned, suggests that the value of the goods and services
to the final consumer presents the aggregate of all the values
added by successive traders or intermediaries in the chain.
Since each trader pays only the VAT attributable to the
value he added at his stage the final tax for any given final
value is same, irrespective of the number of stages in the
process or chain.

The operation of VAT can be viewed as a typical chain of

transactions where goods produce by a manufacturer are
sold to a wholesaler who sells to a retailer who in turn sells
to a consumer. Everybody in the chain except the consumer
gets a refund for the impute VAT he paid on his purchases.
Since the consumer is not entitled to any refund in respect
of the VAT included in the price he paid to the retailer, it is
at this stage that the tax can be said to form part of the net
Cost of the goods purchased by him. (Ezejelue 2001).

Mladineo & Susak (2015)

Using statistical methodology (hypothesis testing) and comparative ratio analysis, this study
investigated the impact of VAT on the profitability of firms in both manufacturing and retail
sectors of the Croatian economy. The key finding is that tax policy is certainly one of the factors
that influence the profitability of enterprises. It concluded that VAT rate change has a statistically
significant relationship or correlation with ROE (Return on Equity) and EBIDTA (Earnings Before
Interests, Depreciation, Taxes, and Amortizations) in the case of manufacturing firms, on the
assumption that any differences between those firms such as firm size or competitive environment
are not significant to VAT rate change impact .

Dalic (2002)

This study examined the impact or price effects of VAT on manufactured goods and services using
the method of regression analysis. A key finding is that a smaller or lowered tax burden does not
automatically flow into or result in profits for the manufacturing firm and concluded that a certain
price sensitivity exists in relation to the lowering of the tax rates and that we can expect some price
decrease for products which will experience a decrease in the tax burden and vice versa as a
result of VAT introduction. The major assumption on which this depends is that all other
conditions in the economic context is unchanged.

Gebresilasse and Sow (2015)

Using difference of differences estimates big firms as a treatment and small firms as control, this
study investigated the impact of the adoption of the VAT on firms by analyzing the introduction
of VAT in Ethiopia in 2003 using panel data of manufacturing firms (1996-2009). It found that as
value added increases, the share of inputs in revenues fall. On that basis, it concluded that VAT
increases both revenue efficiency and production efficiency in manufacturing firms.

Keen & Lockwood (2010)

This study investigated the revenue impact of VAT. Using a method of estimation based on a
system of equations, applied to a panel of 143 countries observed over 25 years, it found that VAT
has a significant but complex revenue impact with a negative intercept effect counteracted by
positive ones.
Similarities and Differences in VAT Literature Reviewed

The above reviewed works are all similar in asserting that the introduction and/or presence of
VAT does have some impact upon manufacturing or otherwise. The main difference though lies
in the fact that each has chosen to focus on his own understanding of what that impact is, be it a
price effect, productivity impact, revenue or cost impact of the VAT imposed.

Manufacturing is dened, according to International Standard Industrial Classication as the physical or

chemical transformation of materials or components into new products, whether the work is driven by
power driven machines or by hand, whether it is done in factory or in the workers home, or whether the
products are sold at wholesale or retail.

This paper contributes to the relatively new literature on value added taxation: the eectiveness of third
party information, and productive eciency on consumption tax. VAT, which is a tax on value added only,
in theory facilitates enforcement through a built-in incentive structure that generates a third-party reported
paper trail on transactions between rms. So rms cannot easily hide a transaction involving a third party
from the government

A recent paper byPomeranz(2013) analyzes the role of third party information for VAT
enforcement through randomized experiments and shows that announcing additional monitoring has less
impact on transactions that are subject to a paper trail, indicating the paper trails preventive deterrence
eect.
We nd in this paper that relative to small rms big rms increase raw material use by the same
percentage than their increase in reported revenue. These results are consistent with the ndings
inCarrillo et al.(2014).
They nd that when rms are notied by the tax authority about detected revenue discrepancies on
previously led corporate income tax returns, rms increase reported revenue but also increase reported
costs, by 96 cents for every dollar of revenue adjustment.
VAT is also supposed to eliminate the cascading eect of output tax, and thus make production more
ecient. Therefore tax systems should maintain full production eciency even in second-best
environments (Diamond and Mirrlees(1971)). This result implies governments should impose tax on
consumption, wages and prots, but not on intermediate inputs, turnover and trade: this is one of the
main reasons why VAT is so attractive to policy makers.

This paper is organized as follows. Section2gives a brief description of the VAT policy in Ethiopia;
section3presents the empirical strategy of the bunching and dierence in dierences estimations; section
describes the rm level data and the main variables used; section5presents and discusses the results;
and section6concludes.

About 140 countries in the world have adopted VAT, which is a tax on consumption. Most these countries
VAT introduced as a replacement for sales tax (like in Ethiopia). Sales tax is charged only to the nal
consumer, but VAT it is levied at all stages in the value chain of production. So in theory, a business itself
pays no tax (only value added taxes) but collects the tax on behalf of the government. This mechanism is
one of the main reason why VAT is popular for state governments. One the shortcoming of VAT is that in
practice, in competitive markets or where there are many non-VAT-registered competitors, a business
may not be able to pass on all of the VAT to customers and thus part of the cost of the VAT may be borne
by the business rather than its customers (Abdella and Cliord(2010)).
VAT paid by a business on purchases is known as input tax, which is recovered from VAT charges on
company sales known as output tax. If output exceeds input in any particular month, the excess is
remitted to