Taxes may be classified based on:
- Administrative collection arrangements: Direct taxes and indirect taxes.
- Tax rates: Progressive, proportional, regressive and digressive taxes
- Tax bases
Classification Based on Administrative Collection Arrangements
This is a tax that requires a taxpayer to remit his tax to the tax authority directly. It is levied on persons and it can vary with the status of taxpayers. Its impact and incidence fall on the same person. This implies that such a tax neither be shifted forward nor backward.
- Direct taxes are related to the ability to pay since the tax rates are chosen with respect to taxpayer’s ability. Consequently they are suitable in achieving income and wealth re-distribution purpose of the state.
- Direct taxes are revenue elastic in that as income of the community goes up; the tax yield also goes up.
- Direct taxes fulfill the central authority’s need for social and economic justice since taxpayers are taxed fairly with continued change in their incomes.
- Direct taxes do not cause distortion in resource allocations thus leaving taxpayers better off than indirect taxes. This is a suitable attitude towards resource allocation because it leaves taxpayers neutral.
- Direct taxes inculcate a spirit of civic responsibility among the taxpayers.
- Direct taxes violate the principle of convenience since they are paid in lump sum.
- Direct taxes are a disincentive to work extra hours i.e. it limits the supply of labour and thus limiting investments and savings.
- It is not easy to attain the principle of vertical equity. The progressive tax can either be too heavy or too low on the various income levels. The basic difficulty lies with the inability to determine taxpayers’ ability to pay.
- It discourages capital accumulation.
- Direct taxes are easy to evade.
- It is expensive to collect because of the many collection points
This is a tax levied on a ‘thing” and paid by an individual by virtue of his association with that “thing”. It is included in the product’s price / service and is unknown to the buyer. The impact could be on one person and the incidence on another through tax shifting, e.g. customs duty, VAT and excise duty.
- Indirect taxes have fewer collection points and making it convenient to collect them
- It is not easy to evade as they are included in the product’s price / service.
- They present no difficulty in definition i.e. there is no room for manipulation of the tax base.
- Since indirect taxes are related to consumption of luxury and semi-luxury goods, increases in such taxes may give incentives to save more and consume less thus providing funds for capital accumulation / formation. Such taxes may free foreign exchange for importing capital goods for development and minimize foreign exchange crisis.
- Indirect taxes are convenient since they are paid in small instalments at times of sale or purchase and therefore it may be argued that they are not burdensome since they are not felt directly.
- They are most relevant to developing countries because the revenue turnover from them is high.
- It is a flexible tax system that can be applied selectively. The rates can easily be modified to suit the central authority’s wishes to steer the economy in the desired direction.
- They are imposed on different types of products consumed by different consumers differently / selectively.
- Indirect taxes can be used as an economic tool in moulding the production and investment activities of the economy by guiding the economic resource allocation to remedy the defects of price mechanism.
- They negate the principle of ability to pay and are unjust to the poor. By their nature, they are spread over to cover items that are purchased generally by the poor thus making them regressive in nature.
- They militate against the objective of least aggregate sacrifice. This ill effect of indirect taxes is sought to be corrected by heavily taxing luxury items. However, such a correction can only be partial since taxing luxuries alone will not yield adequate revenue for the state.
- They feed inflationary forces. They begin by adding to selling prices of the taxed goods without touching on the purchasing power of the taxpayer. The result is that in their case inflationary forces are fed through higher prices, higher cost and wages and again higher prices (cyclical effect of taxes).
Classification Based on Tax Rates
The term tax rate is used to denote the amount of tax per unit of the tax base. The base of a tax is the legal description of the object to which the tax applies, such as net income, output, expenditure, imports, exports etc.
These taxes that take a larger proportion of people’s income when their incomes are increased. It is a tax where, with increased income the tax liability not only increases in absolute terms but also as a proportion of the increased income. The graduated scale rates used in taxing individuals in Kenya are based on this system.
- It conforms to the canon of ability to pay.
- It helps in the achievement of social justice by endeavouring to achieve least aggregate sacrifice of taxpayers’ resources.
- It helps to redistribute economic resources by taxing the rich and applying their excessive wealth on essential services that benefit the poor. This reduces the gap between the rich and the poor.
- It deters the rich from misusing economic resources of luxuries, non-essential goods and services that do not have productive benefit to the society.
- It helps to achieve a state of good health and productivity of masses thereby avoiding a state of civil unrest or social disorder.
- It helps the economy to have firm/stable demand because the rich are heavily taxed during boom periods and also they get high tax credits during the depressed periods.
- It is administered conveniently resulting in less administrative and collection costs.
- It kills the incentive to work harder because extra earnings are taxed off thereby leaving no benefits to hard workers who would prefer leisure.
- It reduces savings ability. The rich save from their excesses to facilitate capital accumulation. However progressive taxes draw all the would be savings to the public spending, thus denying the private sector from saving to invest for further economic growth.
These are taxes that take the same percentage of peoples’ incomes irrespective of their levels of income. The tax increases in the same proportion as the increase in income. This implies a direct linear relationship between the tax payable and amount of income.
- Basing on the human inability to determine the correct degree of progression, proportional tax is assumed to be better.
- It is simple to administer because it is easy to be decided and enforced without requiring complicated rates.
- It does not change the relative position of different taxpayers since each is subjected to the same proportion of tax on his earnings. This implies a quality of neutrality to the allocation of resources.
- It is a regressive tax because it weights heavily upon the poor and leaves the very rich to pay little tax with continued increases in their wealth.
- It negates the principle of least aggregate sacrifice.
This is a tax, which takes a smaller percentage of peoples’ incomes when their incomes increase. People who earn lower incomes are taxed heavily than those who earn higher incomes in relative terms. It implies that the tax rates increase at decreasing rate with increase in income consequently the poor are taxed heavily than the rich on their additional earnings.
- It results in increased earnings of government revenue since the tax base is broadest being based on the majority poor.
- It forces the accumulation of capital formation and savings which the poor would not otherwise save being with a higher propensity to consume. Such capital accumulated may be invested in strategic projects for the benefit of all.
- Wealth is left with the rich to save and invest in strategic private enterprises that promotes the private sector and creates more employment.
- It motivates people to work harder and enter higher income brackets thereby increasing economic wealth.
The tax is called digressive when the higher income earners do not make a due contribution or when the burden imposed on them is relatively less. This will happen when a tax is only mildly progressive i.e. when the rate of progression is not sufficiently steep.
A tax may be progressive up to a limit beyond which the same rate is charged. In that case, there may be lower relative sacrifice for the larger incomes than for the smaller incomes. Another way in which a digressive tax may occur is when the highest percentage is set for that given type of income on which it is intended to exert most pressure; and from this point onwards the rate is applied proportionately on higher incomes and decreasing on lower income, falling to zero on the lowest incomes.
Classification Based on Tax Base
A tax base is a legal description of the object with reference to which the tax applies. Broadly taxes may be classified based on:-
- Current flows of output, income or expenditure e.g. on output – excise duty, on income – income tax e.g. PAYE and Corporation tax, on expenditure- VAT
- Taxes on stocks of capital goods wealth e.g. inheritance tax, capital gains tax.
- Taxes on imports or exports e.g. import duty and export duty.
Each tax base has to be defined legally and it is to be quantified for determining tax liability of taxpayers. When determining a tax base, the cost of collection, administration cost and the tax effect on the economy are put into consideration.
Tax bases can be extended or narrowed by including certain new items that previously were not included or excluding old items that were previously included respectively e.g. VAT.