Tax System

11.1 Tax

A tax is a compulsory levy by Government. Those who are taxed, have to pay the amount of tax to the Government irrespective of any corresponding services or goods received from the government.

Taxes are the most important source of public revenue.

 Characteristics of Taxes

i.      Compulsory contribution: Tax is a compulsory contribution from the people to the government to defray the expenses incurred in common interest. Tax payer cannot expect any direct benefit from payment of the tax.

ii.     Personal obligation: It is the duty of the taxpayer to pay the taxes. It imposes a personal obligation on the taxpayer. In case of direct tax, Tax payer pays his own tax and in case of indirect tax, tax payer collect the tax from the actual consumers and pays off the tax so collected to the government.

iii.    General benefit: Taxes collected by the government are spent for the general welfare of the people. Tax is the major source of revenue for administration of the government.

 Types of Taxes

There are 2 types of Taxes :

-         Direct tax

-         Indirect Tax

 Effect of each Type of Tax

-         The revenue requirements of modern states are so large that both forms of taxation must be used. On grounds of equity and ability to pay, more reliance should be placed on direct taxes. But government should not ignore indirect tax.

-         Indirect taxes are justified for the purpose of raising revenues and for reducing the consumption of harmful articles. Direct tax and indirect tax both have merits and demerits. Both taxes are needed for the government.

-         Government should impose both taxes with proper judgment. Government should try to safeguard the interest of the poor as well as it should try to raise adequate revenue for proper administration of the states.

11.2.1 Direct Tax

 Direct tax are those taxes burden of which cannot be shifted by the tax payers to the other persons. Tax payer individually bear the burden of tax. Income tax is generally considered to be a direct tax because the person, from whom it is collected, has to bear its burden. He cannot shift the burden to anybody else.

Advantages of Direct Taxes

(i)    Direct taxes can be made progressive. The rate of tax can be made flexible with the paying ability of the taxpayer. For higher income level person, higher tax rate may be imposed. For lower income level person, lower tax rate may be imposed.

(ii)    Through direct taxes, inequality of incomes and wealth can be decreased.

(iii)   Monetary burden of direct taxes is known beforehand, as laid down in statutes. The monetary burden of an indirect tax depends on the amount of purchases.

(iv)   Direct taxes are economical, because the cost of collection is usually low. So, direct taxes, like the income tax and death duties, are highly productive.

(v)    The burden of direct taxes is clearly felt and as the payers themselves pay the Tax.

Disadvantages of Direct Taxes

i.      Direct taxes, like the income tax, involve enquiries into the private affairs of citizen, often many persons invading on their private information.

ii.    Direct taxes are payable in lump sums and are therefore inconvenient and unpopular.

iii.   Direct taxes tempt preparation of false accounts and other forms of tax evasion.

11.2.2 Indirect Tax

Indirect tax an those taxes burden of which can be shifted by the tax payer to the other person. Tax payer collect the indirect tax from the actual consumers. Sales Tax is an indirect tax because it is collected from sellers but the sellers do not pay it from their own pockets. They add the tax to sale price and get the money from the buyers. So, the actual incidence of sales tax is ultimately borne by the buyers of the goods.

Indirect taxes provide maximum revenue to union government.

Advantages of Indirect Taxes

1. Some indirect taxes are highly productive (e.g. the sales tax). Government collects a huge sum from indirect tax because scope of such tax is very wide.
2. They are paid by all classes of people. Poor people can escape direct taxes but not the indirect ones, imposed on consumption goods. Indirect taxes therefore make the tax system broad based. Though indirect taxes are small amount but due to pervasiveness, collection from indirect tax is huge.
3. They are convenient because payment is made in small amounts when goods are actually purchased.
4. Indirect taxes can be made instruments of social reform. High taxes on drugs and intoxicants restrict their consumption. To control the consumption of products injurious to health, Government impose high rate of indirect tax on those products.

Disadvantages Indirect Taxes

1. Indirect taxes have no link with income level of tax payer. They are more burdensome to the poor. The poor cannot avoid the payment of indirect tax because it is imposed on goods. So, in case of high rate of indirect tax, the poor suffers most.
2. The cost of collection is often high, because government has to keep large administrative machineries to manage the tax collection system. The scope of indirect taxes is very wide. So, government has to watch every segments wherefrom government may collect indirect taxes.

 11.5 Canons of Taxation

Canons of taxes as per  Adam Smith

          i.    Canon of Ability / Equity: This canon is also termed as the ‘canon to equity’. According to this canon, a good tax is one whose burden is equitably distributed. In other words, we can say that a good tax is one, which is imposed according to the ability to pay. The principle of ability is accepted in modern times as just and equitable. As every person pays according to his ability, there is equality of sacrifice.

        ii.    Canon of Economy: This canon lays down that the cost of collecting a tax should be small in proportion to the yield. The cost of a tax should not be interpreted only on administrative expenses. If a tax has a effect on production or distribution, it is considered costly from the standpoint of the economy as a whole. On the other hand, if a tax has a good effect on the national economy, it is justified even though its yield is small and administrative expenses are high.

       iii.    Canon of Certainty: A good tax should also satisfy the canon of certainty, i.e. the amount of tax to be paid should be certain. If the amount of tax or the time of payment is left to the whim of the tax.  Collector tax payers would be put to a lot of trouble and corruption and bribery will follow.

       iv.    Canon of Convenience:  A good tax is one, payment of which would cause the least inconvenience to the payer. The canon really means that the time of payment should be so fixed as to cause the least inconvenience.

Canons of taxes as per  other economists

Besides the above canons of taxation suggested by Adam Smith; some other economists have also suggested certain other canons of taxation, as follows:

          i.    Canon of Productivity: A good tax is one, which can produce the sufficient amount of revenue to meet the various expenditure of the government. This canon states that the net yield of tax should be considered before imposing it (except the cases of taxes which are not imposed for revenue).

        ii.    Canon of Elasticity: The tax system should be elastic, i.e. the revenue from it should increase or decrease with an increase or decrease in the national income.

       iii.    Canon of Simplicity: As far as possible, the tax system should be simple. This canon means that taxes and the tax system should be understandable to the ordinary persons.

       iv.    Canon of Diversity: This canon requires that there should be a number of taxes of different varieties so that the income of every class of citizen may be taxed. Every person must be obliged to pay, directly or indirectly, something to the national income.  

Progressive Tax

  i.    A progressive tax is a tax which is imposed considering the ability of an individual to pay (e.g. Income Tax). The rate of taxation rises with the increase in income. Higher the income, higher is the rate of taxation.

ii.    Progressive tax is favoured because it is based on Principle of equity and is a powerful tool for reducing inequality. However it is criticized on grounds that it retards capital formation, hampers social welfare and is sort of punishment to hard work.

Proportional Tax

Under the proportional tax system, the tax is levied on all levels of income at an uniform rate. It is always in proportion to the income or property. For example, if the rate of tax is 5 percent on income, all the persons will have to pay at 5 percent irrespective of the income and therefore, nobody will be spared.  

11.6 Types of taxes

(i)    Income Tax: Income tax is imposed on income whether actual or deemed, cash or in kind. Imposition and collection of taxes on income (excluding agricultural income) is within jurisdiction of the Central Government. The net tax collections are distributed between the Centre and the states as per the recommendations of Finance Commission, appointed by the President of India in every five years. Income tax is a direct tax. Income tax tries to reduce the inequality of Income.

Agricultural Income in India is generally exempted but it is considered for rate purpose. 

(ii)    Wealth Tax: Wealth-tax is a tax on wealth. It is charged on net wealth of an assessee. Wealth tax is a direct tax. It is collected by the income tax department.

(iii)   Gift Tax: Gift tax is levied on donations. Now gift tax has been abolished.

(iv)   Custom Duties: The tax levied on export and imports are termed as custom duties. Custom duty is an indirect tax. Custom department is entrusted with the responsibility of collecting custom duties.

(v)    Octroi : Octroi is a local tax, it is levied and collected by local bodies. 

(vi)   Service tax: Service tax was introduced in 1994-95. It is levied on services provided. 

11.6.1 VAT

Value added tax is levied on the sellers of goods based on value added by them. It falls on the value added at each stage from the stage of production to retail stage. VAT removes the cascading effect of taxation (i.e. tax on tax). Under VAT system, registered dealer is entitled to adjust input VAT against output VAT. Dealer need to pay only difference between output VAT and input VAT, to the government. Input VAT means the VAT on the goods purchased. Output VAT means the VAT collected from the customers at the time of selling the goods.

Merits of VAT: Following are the main advantages of VAT:

(i)    Simple: It is easier to assess tax liability of a firm by using the credit method. There is greater scope for cross checking of returns submitted by firms.

(ii)   Minimum scope for tax evasion: VAT minimizes scope for tax evasion because (a) the tax is divided into parts and therefore the incentive to evade tax by any one firm is reduced, and (b) it is in the interest of a firm to account for the taxes paid by earlier firms through which the inputs have come. If any firm understates its output, it will be caught by the disclosures of the firms buying inputs from it. Firms are allowed to take input audit on purchase, if they maintain all purchase records.

(iii) Conducive to efficiency: VAT is conducive to efficiency since a firm is not exempted from its tax liability even if it runs into a loss. It pays a tax on the value produced (not on its profits). It, therefore, tries to improve its performance, and reduce the cost of production.

Demerits of VAT   

(i)    Complicated system: In theory though VAT is a single uniform rate tax without any exemption, but in practice, it has got to be multi-rate system with exemption to certain industries. It is necessary that the country adopting it should also be sufficiently advanced in its financial and economic structure and the firms should be in the habit of keeping proper accounts. Record maintenance and proper adjustment of output VAT with Input VAT is rather a complicated process.

(ii)   Less Revenue to the state: Unless the rates of VAT are extraordinary high, the state may end up with smaller tax revenue as against the collection from sales tax. VAT is imposed only on value addition, not on total sales value. So, collection of tax may be lower.

(iii) Maintaining accounts: VAT forces traders to maintain elaborate and costly accounts. This becomes uneconomical, especially for the smaller firms. To get input credit against output VAT, firms have to keep all the records relevant to purchase & sale.

11.6.2 CENVAT

CENVAT is actually excise duty imposed on manufactured goods. At the time of removal of finished manufactured goods from the factory, CENVAT should be charged. Under CENVAT system, manufacturers are allowed to take input credit on raw materials purchased against CENVAT collected from finished goods. Net excise duty payable is paid by adjustment against personal ledger account balance. CENVAT is an indirect tax administered by central excise department. Central government collects highest revenue from exercise duty. It helps in reducing cascading effect of input taxation.