EXPLAIN THE EFFECT OF TAXATION ON:

A, PRODUCTION.
A tax is an involuntary fee or, more precisely, "unrequited payment" paid by individuals
or businesses to a government. Taxes may be paid in cash or kind (although payments in
kind may not always be allowed or classified as taxes in all systems). The means of
taxation, and the uses to which the funds raised through taxation should be put, are a
matter of hot dispute between political parties and economic theorists, so discussions of
taxation are frequently tendentious.

Governments collect taxes:

• to support the operation of that government itself;

• to influence the macroeconomic performance of the economy (the government’s
strategy for doing this is called its fiscal policy);
• to carry out the functions of the government, such as national defence, and
providing government services
• To redistribute resources between individuals or classes in the population.
Historically, the nobility were supported by taxes on the poor; modern social
security systems are intended to support the poor by taxes on the rich.
• To modify patterns of consumption or employment within an economy, by
making some classes of transaction more or less attractive.

The resource taken from the public through taxation is always somewhat greater than that
than the amount which can be used by the government. The difference is called
compliance cost, and includes for example the labour cost and other expenses incurred in
complying with tax laws and rules.
The collection of a tax in order to spend it on a specified purpose, for example collecting
a tax on alcohol to pay directly for alcoholism rehabilitation centres, is called
hypothecation. The practice is often disliked by finance ministers, since it reduces their
freedom of action. Some economic theorists consider the concept to be intellectually
dishonest since in reality money is fungible.

Economists, especially neo-classical economists tend to argue that all taxation distorts the
market and results in economic inefficiency. They have therefore sought to identify the
kind of tax system that would minimise this distortion. A popular theory is that the most
economically neutral tax is a tax on land. A government's primary duty is to maintain and
defend title to land, and therefore (so the theory goes) it should collect most of its
revenues for this unique service. Since governments also resolve commercial disputes,
especially in countries with common law, this doctrine is often used to justify a sales tax
or VAT (value-added tax).

To further show what the effect of taxation has on the economy and thus on production
we will use some illustrations below.

Some economists view taxes as creating inefficiencies in the economy.

Figure 1: Equilibrium
Figure 1 indicates a good without any government interference. This good could
represent anything from televisions to labour. At this equilibrium quantity Q1 of the good
are sold are price P1. The consumer and producer surplus are both high.

Figure 2: With a tax

Figure 2 shows the introduction of a very simple tax. The tax charges a flat fee whenever
a consumer wishes to purchase the good. The price thus rises to P2, and since fewer
consumers wish to purchase the good at the higher price, the quantity produced falls to
Q2. The government receives the amount of the tax for each unit sold, and this amounts
to the region shown in grey. This is the amount of revenue the government receives for
this tax.

Note that in this situation the price of the good to consumers only increases by half the
amount of the tax, the other half of the tax is borne by the producer. Thus both consumer
and producer surpluses shrink by equal amounts. For many goods this is not the case.
Who bears the cost of the tax is determined by the elasticity of the good. For inelastic
goods like cigarettes, and gasoline almost all of the tax is paid by the consumer.
B, EMPLOYMENT

Every combination of the various forms of taxation has a different effect upon welfare,
but they all have certain common features. In the terminology of economic theory, each
of them has an income effect, and most of them have substitution effects. The income
effect is the reduction in the resources available to taxpayers that are brought about by the
transfer of resources to government. It occurs, therefore, without affecting the total of the
country's resources. The substitution effect, on the other hand, may result in a reduction
in the country's resources by bringing about a move to less productive activity. An
increase in income tax may, for example, induce a skilled worker to reduce his working
hours and spend more time on untaxed do-it-yourself activities. The resulting reduction in
output would have the indirect effect of reducing national welfare. The substitution effect
may alternatively have a direct effect of welfare by prompting taxpayers to buy products
other than those that they would otherwise prefer. A tax on biscuits, for example, may
prompt buyers to switch to an untaxed but less enjoyable product, such as bread. The size
of the substitution effect depends upon the extent to which the tax varies with a level of
activity (the marginal tax rate) and to the responsiveness of the level of that activity to its
price (the elasticity of supply or demand). Taxes that have no effect upon supply or
demand, such as a land-value tax or a poll tax, have no substitution effect, and activities
whose level is relatively insensitive to price (such as purchases of bread) have relatively
small substitution effects. Other things being equal the more numerous the persons or
activities on which the tax is leveled (i.e. the larger the tax base), the smaller is likely to
be the substitution effect because the lower are the marginal tax rates

A second common feature is the effect of taxation upon the distribution of income and
wealth. Taxation may be expected to alter the distribution of income or wealth. The term
‘’vertical distribution’’ refers to distribution among people having different levels of
income, and the term ‘’progressive tax’’ denotes a tax which bears progressively more
heavily on higher- income taxpayers. However, a tax which is the same whatever the
taxpayer’s income, such as a poll tax, is termed ‘’regressive’’ because it is harder for
Low-income taxpayers to afford it. The term ‘’horizontal distribution’’ is
correspondingly taken to refer to the distribution of taxation among taxpayers who have
similar levels of income, but the term is open to a variety of interpretations. The
reduction of, or exemption from, tax liability for specific classes of potential taxpayer is
often referred to as a ‘’tax break’’ and is indistinguishable from subsidies in favour of
those classes. Tax breaks for specific activities, such as research and agriculture - or for
specific classes of organisation, such as charities, are intended to encourage those
activities or organisations; and tax breaks for specific classes of individual such as the
elderly or mothers with small children, are often intended to alter vertical distribution.

The burden of taxation may not be confined to those who pay the tax, however.
Producers may be able to pass a part of any tax increase taxes on to consumers by
increasing prices or on to employees by reducing wages, and employees may be able to
pass a part of any income tax increase on to producers by raising wages. The extent to
which such shifting of the tax burden occurs depends upon conditions in the relevant
product and labour markets.

Effects of individual taxes

Personal income tax

Taxes on employment income can affect the supply of labour as a result both of its price
effect - to the extent that it makes employees try to compensate for their loss of after-tax
earnings - and its substitution effect - to the extent that it makes employees willing to
sacrifice their reduced net earnings in exchange for the benefits of increased leisure.
Empirical evidence tends to indicate that income tax has a negative effect the effect that
is larger for female labour than for male labour, and that it is greater for both when tax
rates are progressive. The combined influence of employment income taxation and
means-tested state benefits can also reduce the supply of labour as a result of the
operation of the unemployment and poverty traps.

Taxes on employment income can also affect the demand for labour as a result of the tax
wedge that is driven between he cost of labour to employers and the net payment
received by employees. The magnitude of the effect upon unemployment depends upon
the price flexibility in the relevant labour market, because it depends upon the extent to
which employees are able to pass a tax increase on to their employers.

The substitution effect of personal taxation may be expected to reduce the motive for
saving as a result of the reduced after-tax return but the income effect may prompt an
increase in savings in order to preserve a desired level of retirement income. Empirical
evidence concerning the magnitude of the net effect has yielded widely differing findings
but there is general agreement that the outcome is a reduction in savings. There is also
some evidence to suggest that income tax may reduce human capital as a result of its
effect upon the willingness of parents to spend money on their children.

Income tax is usually used to reduce inequality by taking a proportion of income that
rises with rising income (an arrangement that is termed "progressive"), but the increased
marginal tax rates that result may be expected to magnify the above effects.

Corporate income tax

There is no apparent advantage to be gained from adding the indirect taxation of the
sources of investment income by taxing company profits to its direct taxation as part of
personal income taxation - although it was suggested in the Meade Report that it might be
considered to be a payment for the privileges of limited liability. A tax on corporate
profits has the drawback of discouraging investment by reducing its rate of return
(although alternatives can be envisaged that avoid that disadvantage). Investment
decisions are distorted if debt and equity are treated differently but other difficulties can
arise if that is to be avoided. Also, international differences in tax treatment can influence
location decisions, especially of multinational companies - a consideration that has
probably acted as restraint upon governments.
 EXPLAIN THE MERITS AND DEMERITS OF VAT IN
KENYA

ADVANTAGES

1) Coverage

If the tax is carried through the retail level, it offers all the economic advantages of a tax
that includes the entire retail price within its scope, at the same time the direct payment of
the tax is spread out and over a large number of firms instead of being concentrated on
particular groups, such as wholesalers or retailers.

If retailers do evade, tax will be lost only on their margins because customers that are
registered firms gain nothing if their suppliers fail to collect tax, except delay in payment;
they will pay more to the government themselves. Under other forms of sales tax, both
seller and customer gain by evading tax. One particular advantage is that of the widening
of the tax base by bringing all transactions into the tax net. Specifically, VAT gives the
new government the opportunity to bring back into the tax system all those persons and
entities who were given tax exemptions in one form or another by the previous regime.

2) Revenue security

VAT represents an important instrument against tax evasion and is superior to a business
tax or a sales tax from the point of view of revenue security for three reasons.

In the first place, under VAT it is only buyers at the final stage who have an interest in
undervaluing their purchases, since the deduction system ensures that buyers at earlier
stages will be refunded the taxes on their purchases. Therefore, tax losses due to
undervaluation should be limited to the value added at the last stage. Under a retail sales
tax, on the other hand, retailer and consumer have a mutual interest in under declaring the
actual purchase price.

Secondly, under VAT, if payment of tax is successfully avoided at one stage nothing will
be lost if it is picked up at a later stage; and even if it is not picked up subsequently, the
government will at least have collected the VAT paid at stages previous to that at which
the tax was avoided; while if evasion takes place at the final stage the state will lose only
the tax on the value added at that point.

If evasion takes place under a sales tax, on the other hand, all the taxes due on the product
are lost to the government.
A significant advantage of the value added form in any country is the cross-audit feature.
Tax charged by one firm is reported as a deduction by the firms buying from it. Only on
the final sale to the consumer is there no possibility of cross audit.

Cross audit is possible with any form of sales tax, but the tax-credit feature emphasises
and simplifies it and is likely to make firms more careful not to evade because they know
of the possibility of cross check.

3) Selectivity

VAT may be selectively applied to specific goods or business entities. We have already
addressed essential goods and small business. In addition the VAT does not burden
capital goods because the consumption-type VAT provides a full credit for the tax
included in purchases of capital goods. The credit does not subsidize the purchase of
capital goods; it simply eliminates the tax that has been imposed on them.

Co-ordination of VAT with direct taxation

Most taxpayers cheat on their sales not to evade VAT but to evade personal and corporate
income taxes. The operation of a VAT resembles that of the income tax more than that of
other taxes, and an effective VAT greatly aids income tax administration and revenue
collection. It is interesting to note that when Trinidad and Tobago set out to introduce
VAT it chose one of its top income tax administrators as the VAT Commissioner.

It must be stressed once again that if properly implemented VAT can ultimately lead to a
reduction in overall rates of tax.

Revenues will not be sacrificed but would in fact be enhanced as a consequence of the
broadened tax base. This does not seem to be a bad idea at all.

DISADVANTAGES

The main disadvantages which have been identified in connection with the Value Added
Tax are:

1) VAT is regressive

It is claimed that the tax is regressive, i.e. its burden falls disproportionately on the poor
since the poor are likely to spend more of their income than the relatively rich person.
There is merit in this argument, particularly if it attempts to replace direct or indirect
taxes with steep, progressive rates. However, observation from around the world and
even Guyana has shown that steep tax rates lead to evasion, and in the case of income tax
act as a disincentive to effort.
Further, there is now a tendency in most countries to reduce this progressivity of taxes as
has been done in Guyana where a flat rate of income tax has been introduced. In any case
VAT recognises and makes room for progressivity by applying no or low rates of tax on
essential items such as food, clothes and medicine. In addition it allows for steep rates of
tax on luxury items, although this can create problems for administration and open
opportunities for evasion by way of deliberate misclassification, a problem incidentally
not peculiar to VAT, and which takes place extensively in the area of customs duties.

2) VAT is too difficult to operate from the position of both the administration and
business.

(a) The administration

It is often argued that VAT places a special burden on tax administration. However, it is
worth noting that wherever VAT was introduced one of its effects was the rationalisation
and simplification of the previous indirect tax system and its administration. Each of the
previous indirect taxes such as customs duties, purchase tax and excise duties replaced by
VAT had its own rate structure as well as a different tax base and separate administrative
procedure. The consolidation and incorporation of numerous indirect taxes into the VAT
would simplify the rate structure, tax base, and administration of the indirect tax system,
thereby eliminating the overlapping auditing practices that had plagued those systems.

In addition, the abolition of a number of alternative indirect taxes releases experienced

personnel to focus on a single tax. It also means reduction in the number of forms used,
legislation to be applied and returns and accounts with which the business person has to
contend.

(b) Business

It is true that the VAT is collected from a larger number of firms than under any form of
income tax or single state sales tax; to the typical smaller firms the complexities of the
tax and the need for more extensive records (for example, to justify deductions) are likely
to prove serious.

However, it is often overlooked that businesses already function with considerable

administrative responsibility for a number of laws including the National Insurance Act
and the Income Tax Act.

Under the Income Tax (Accounts and Records) Regulations of 1980 every person,
without exception is required to maintain detailed and extensive records of all its
transactions. Compliance with this will certainly ensure compliance with VAT
regulations, and since there is an actual benefit to be derived from accounting for VAT
paid on input there is an incentive for proper record-keeping.

As we have noted before, VAT also allows for the exemption of small businesses from
the system.
Under any form of sales taxation, small businesses have to be granted special treatment
because of their inability to cope with the requirements of keeping adequate records
which larger enterprises can handle at a reasonable cost. The intent of the special
treatment is to reduce the administrative burden on small enterprises, but not the taxes
that normally would be charged on the goods and services they supply. The revenue loss
at the final link in the commercial cycle is limited only to the value added at that stage,
whereas in the case of income tax or sales tax the entire tax is lost. To recover the loss
from exemptions, a flat tax on turnover may be applied.

In the larger businesses with proper staff and computers, the task is really one of double
entry book-keeping and any additional work is hardly ever noticed.

3. VAT is inflationary

Some businessmen seize almost any opportunity to raise prices, and the introduction of
VAT certainly offers such an opportunity. However, temporary price controls, a careful
setting of the rate of VAT and the significance of the taxes they replace should generally
ensure that there is no increase if any in the cost of living. To the extent that they lead to
a reduction in income tax, any price increases may be offset by increases in take-home
pay.

In any case, any price consequence is one time only and prices should stabilise thereafter.

4. VAT favours the capital intensive firm

It is also argued that VAT places a heavy direct impact of tax on the labour-intensive firm
compared to the capital- intensive competitor, since the ratio of value added to selling
price is greater for the former. This is a real problem for labour-intensive economies and
industries.