Rationale for public sector involvement or intervention in the economy
 Introduction
 Reasons for government involvement in the economy
 Market failure , types of market failures
 Causes of market failure; Public goods, Externalities , merit goods and Demerit goods
 Types of government intervention- How Government get involved in the economy
 Scope of government activity
 Government Failures, reasons, causes

Introduction
Economics is the study of how society allocates its scarce resources.
Government intervention is any action carried out by the government or public entity that affects
the market economy with the direct objective of having an impact in the economy, beyond the
mere regulation of contracts and provision of public goods.
The presence of the state sector in an economy is justified on grounds of failures of an unregulated
market mechanism. The state has numerous beneficiary roles to play including the allocative,
distributive and stabilizing ones. Without government intervention the pattern of reserve
allocation, production, demand and consumption do not result in conformity with the needs and
aspirations of the society.
Reasons for Government Intervention/Involvement in the Economy:
Government frequently intervenes in markets either:
1. Because of market failures, or
2. To achieve particular social objectives, such as reducing poverty or to improve
the health and well-being of individuals.
3. To improve the performance of the economy
What is market failure?
Market failure – is a situation where the market is not Pareto efficient. What is Pareto
efficient? Pareto efficiency is defined as a situation where it is not possible to make one party
better off without making another party worse off. Pareto efficiency is a situation where resources
are distributed in the most efficient way.
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Example; Pareto efficiency. Assume the government intends build a new airport, there will be
winners and losers as shown.
 The private and external benefits are estimated at £20bn
 The cost of building airport is £13bn
 Residents living nearby see a loss in personal welfare of £1bn
 The net benefit to society is £20bn- £14bn. A clear gain of £6bn

However, using principles of Pareto efficiency –living nearby lose out while at the same time
society benefit. What should we do? The scheme has a net welfare gain – but some lose out.

One option is to make the airport company compensate local residents for the inconvenience of
losing out.
In this way, the airport goes ahead, and the company makes a profit, but local residents are
compensated for losing out.

Another Example that of giving to charity
Firstly it depends on how you define utility. If a billionaire gives money away to charity – he has
less money – so from one perspective, he is financially worse off. If Bill Gates gives money to
Rwanda, his wealth declines and Rwanda becomes wealthier.
NB; Market failure is the opposite of a situation where markets are efficient (Pareto efficiency).
An example
We have all had the experience of running to the store to pick /buy an item that we require only to
find that the item/product is out of stock. What do we do? We can choose to wait until the item/
product come back in the stores again or we can grab a replacement / an alternative product.
Now as we pick the replacement product we will ask ourselves why does the store supply enough
products to meet the demand of consumers? The answer to this question is market failure and this
introduces the concept of market failure.
Market failure is an economic term applied to a situation where consumer demand does not equal
the amount of a good or service supplied, and is, therefore, inefficient. Market failure occurs when
products that consumers demand do not equal the amount of supply offered. Therefore any time
the markets fail to allocate resources the situation results in market failure.
Types of market failure
There are two types of market failure namely;
 Complete market failure – this happens when a market does not supply any product at
all.
 Partial market failure – in this case product are supplied however market produces either
wrong quality or charges the wrong prices.
What are the causes of market failure
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Markets can ‘fail’ as a result of
 Public goods,
 Externalities,
 Information problems / asymmetric information
 Market power/ concentrated market power
Public good
What are public goods; they good that exhibit the following characteristics;
 non rival
 non excludable
 Indivisibility
Public goods are non rival. The non rival means that consumption of the good by one party does
not affect or reduce/prohibit consumption of the same good or service by another party. e.g street
lighting, the broadcast of a TV series is an example of a nonrival good. If I watch a specific
episode, you could also watch that same episode. A rival good on the other hand means that
consumption of a good or service by one party prevents its consumption by another party. An apple
is one example. If I ate an apple, you could not eat that same apple. This is a feature of a private
good.
Public goods are non excludable. The non excludable means that nobody can be excluded or
prevented from consuming a good i.e even those who do not explicitly (actually) pay for the good
can benefit from the good. A nonexcludable good is one where nonpaying consumers cannot be
prevented from accessing the good.
A typical example is that of defense service. Once the country is protected against foreign
aggression, no section of the society can be excluded from enjoying its benefits. The defense
service is therefore indivisible. Take a country like Kenya and one person from Tanzania enters
Kenya. By him coming to Kenya he does not make prevent or make it harder to anybody else in
the country not to enjoy defense. Secondly it will be harder for the country to say we will have
our military defend everybody and leave out this person ( Tanzanian).
Indivisibility – it is argued that non-rivalriness, emanates from the indivisibility of public goods.
All public goods by nature and form are lumpy and cannot be feasibly sub-divided into parts for
individual consumption or ownership.
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Because of characteristics of Public goods, the principle of exclusion does not apply to it. They
cannot be delivered through a price mechanism because the individuals are not obliged to pay for
use. The delivery of public goods by market mechanism/ private companies or organizations can
lead to the “free-rider” problem. The free-rider problem can happen when enough people can enjoy
a good or service without paying for the cost to supply it. In free market there will be a danger, the
good will end up under-provided/ supplied in limited quantities or not provided at all by a private
company. The assumption is that private companies and organizations won’t supply something if
they know they will lose money on it. In that case, many economists believe there is a role for
government, rather than private companies, to provide or subsidize those goods or services using
taxpayer money.
Therefore, the provision of such a good lies on contributions (like taxation) by the members of the
society. Their financing cannot be left to market mechanism. This implies that public goods
should be provided by the public sector only.
Therefore for public goods, market failure exists due to non-rival consumption and nonexcludability nature -making it necessary for the government to create a budgetary provision in
maintaining a healthy economy.
Definition of private good, merit good and demerit good

Private good – exhibits both excludability and rivalrous. Excludability means that its owners
can exercise private property rights, preventing those who have not paid for it from using the
good or consuming its benefits and rivalrous means that consumption by one consumer
prevents simultaneous consumption by other consumers.
NB. Private goods satisfy an individual want while public goods satisfy a collective want of
the society.
 Merit good - are those goods and services that the government feels that people will underconsume if left to the market forces or private enterprise, and which ought to be subsidized or
provided free at the point of use so that consumption does not depend primarily on the ability
to pay for the good or service.
NB; they are provided by both the public and private sector such as education and vaccination
among others
Demerit Good -are goods which have negative externalities resulting from their
consumption. This means that consumption of the goods result in external costs – costs that fall
on people other than those consuming the goods. An example of demerit good is
cigarettes. Smoking causes additional health cost (external costs) that are paid by the rest of the
population
Externalities
An externality sometimes called “spillovers” or “neighborhood effects,” Occurs when one party
undertakes an action that has effect on another party who is not directly for which the former does
not pay. In other words, externalities refer to economic effects which flow from the production or
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use of the good to other parties or economic units, which are called spill-over effects. Externalities
are the effects of a decision on a third party that are not taken into account by the decision-maker
Types of externalities:
a) Positive externalities – these are beneficial e.g. recycling of waste for biogas, creates
forms of renewable energy
b) Negative externalities – these are considered to be harmful and detrimental to others, e.g.
smoking and loud music.
c) Pecuniary externalities – these result from economic gains or loss to other economic units
e.g. influx of immigrants with high incomes can drive-up rental prices in a certain locality.
Externalities pose problems for markets because the price of a good or service associated with an
externality does not reflect the total societal benefits or costs from those goods or services. As a
result, companies or organizations will produce too many or too few goods or services, depending
on the externality.
How does the government deal with positive externalities?
The government plays a major role in dealing with externalities
Positive externalities to subsidize goods or services that generate positive externalities—often via tax breaks—
because of the positive effect a company or organization is having on a community,
whether inadvertently or intentionally.
 Evoking a reward system for positive externalities.
Negative externalities?
 Direct regulation- here the government limit the amount of a good people are allowed
to use.
 Incentive policies- Market incentive and tax policies
 Market incentive – these are plans that require the market participants to certify that they
have reduced total consumption by a certain amount. Market incentive is similar to direct
regulation in that the amount of good consumed is reduced. However market incentive plan
differs from direct regulation because individuals who reduce consumption by more than
the required amount receive marketable certificates that can be sold to others. Incentives
are more efficient than direct regulatory policies.
 Tax policies
Government can tax or fine negative externalities to influence companies to reduce that
harmful spillover.
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The government responds to such externalities by regulating the activity in question, imposing
emission standards on automobiles. Alternatively, the government may attempt to influence the
price system, by imposing fines on negative externalities and evoking a reward system for positive
externalities.
Information problems / Asymmetric information
Efficient markets require high levels of transparency and free flow of information. In the real
world, buyers and sellers do not usually have equal information, and imperfect information can be
a cause of a market failure. When one party in a transaction has better information than the other
party involved, then there’s opportunity for exploitation. • An adverse selection problem is a
problem that occurs when buyers and sellers have different amounts of information about the good.
A classic economic example is the “Lemon problem.” In the market for used automobiles,
information asymmetry occurs when sellers know more about what they are selling than consumers
do. The consequence is that buyers may unknowingly purchase cars with defects (lemons) at a
higher price than they would have been willing to pay if they had information about the defects.
Signaling may offset information problems. Signaling refers to an action taken by an informed
party that reveals information to an uninformed party that offsets the false signal that caused the
adverse selection in the first place. Selling a used car may provide a false signal to the buyer that
the car is a lemon. The false signal can be offset by a warranty.
Today, warranties and online information services, such as Carfax for the auto market, help address
these problems and mitigate the “Lemon problem” for consumers.
In some markets it can be difficult for consumers to be certain about the quality of a good or service
before they buy it. This can disadvantage suppliers of better quality products because they will
find it difficult to convince customers to pay the higher prices which are necessary to cover any
additional costs the producers have incurred. In some extreme cases this mismatch could lead to
the collapse of the market: if consumers cannot judge the quality of a product, they may end up
buying nothing.
NB; Market failure may result due to under production of information. This reduces the ability
and scope of consumers to make rational decisions e.g. a firm may not be aware of prices of input
in latest technology, therefore fail to pass economies of scale to the consumer. The above therefore
raises the questions of policy formulation-which includes: should the government bear the
responsibility of providing the population with the information?
Policies to deal with information problem
Government can intervene to help overcome these problems and empower consumers to make
informed choices. For example,
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 Government can regulate the market and ensure that individuals provide correct
information. Government can require appropriate labeling showing the energy efficiency
of electrical products.
 Government can also address the problem by educating consumers to better understand
complex products and services, such as financial products.
 License individuals in the market and require them to provide full information about the
good being sold. Example is licensing of doctors. Medicare is an example of imperfect
information. Patient usually does not a way of knowing if a doctor is capable... current
practices require medical licenses to establish a minimum level of competence. Another
option is to provide the public with information on; Grades in medical school, success rates
of various procedures, charges and fees and referees.
Market power/ concentrated market power
In markets with high levels of competition, companies and organizations have an incentive to
produce goods and service that consumer’s value, at low cost. If they do not meet consumer
demand or fail to keep prices low, then the company or organization will lose money or go out of
business because consumers can easily find substitutes elsewhere. Agricultural crops, such as corn
or soybeans provide an example of highly competitive markets. Many farmers produce similar
crops. Farmers who produce bad-tasting corn or who price their corn too high will likely lose
customers because those customers can easily find other corn that’s better or cheaper elsewhere.
In contrast, a monopolist is the only producer of a good or service, and market power is
concentrated in the hands of a single producer. There are no other producers, no other appealing
substitutes and the single organization has so much power, no other competitor can gain footing
in the market without help from some other intervention (economists refer to this as “barriers to
entry”). As a result, consumers are in a weak position to influence the monopolist’s behavior
because they have nowhere else to get that good or service.
Under a monopoly, the company or organization will produce too little or poor quality goods or
services while pricing them above marginal cost. Markets like this will operate inefficiently, too.
The existence of monopolies in certain industries, creates the market failure due to imperfect
competition. Monopolies imply that there is an absence of strong competition. However, the
presence of only a few firms in itself does not necessarily mean that firms are not acting
competitively if there are a large number of potential entrants.
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How do monopolies or market power arises?
Some monopolies are created by the government through patents systems.
Natural monopoly- In this case a firm attains a monopoly position as a result of increasing returns
of scale, In other instances, there are barriers to enter arising from what economists refer to as
increasing returns of scale. This is where the cost of production per unit output declines with the
scale of production. (e.g water supply, electricity, transport, postal services, etc.)., are Artificial
monopolies- whereby potential competitors are prevented from entering the market by the
government legal restrictions or regulations by a professional body e.g. the law society of Kenya.
Where there is a single monopoly firm, Government may also choose to regulate market power
more directly – for example, through price controls.
Example showing of causes of market , consequences and possible government
intervention.
Type of
Market
Failure
Consequence of
Market Failure
Failure of market to
provide pure public
Public
goods, free rider
goods
problem
Over consumption
of products with
Demerit
negative
goods
externalities
Under consumption
Merit
of products with
goods
positive externalities
Higher prices for
Monopoly consumers causes
power in a loss of allocative
market
efficiency
Damaging
consequences for
Imperfect
consumers from
information poor choices
Example of Government Intervention
Government funded public goods for collective consumption
Information campaigns, minimum age for consumption
Subsidies, information on private benefits
Competition policy, measures to encourage new firms into a market.
Statutory information / labeling
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Types of Government intervention
 Direct Government participation in market. The govt intervene in the market to provide
public goods and services that free markets would be unlikely to provide. Government is
also a significant buyer of goods and services from the private sector. Government buys
from the private sector in order to deliver public services and also to carry out its functions,
for example the provision of offices, IT equipment and research services. Government
typically procures goods and services through a competitive tendering process. Potential
suppliers bid for contracts, and the contract is awarded to the firm that best meets the
specified criteria and provides the best value for money.

Acting as a supplier- Through direct provision of goods and services to the public, and as
collector and holder of public sector information

Acting as a buyer- Through competitive tendering
 Indirect Government participation in markets- Government usually intervenes
indirectly where private markets exist but produce side-effects that have an impact, either
positive or negative, on social welfare.


Through taxes- When a negative side effect exists ( negative externatilies), for example
pollution from car exhausts, Government can choose to discourage its production (for
example, vehicle tax) and/or its consumption (for example, petrol or road tax).
Through subsides - When a side effect exists that is beneficial to society and should be
encouraged, for example research and development, Government can choose to subsidise
it thereby encouraging production and/or consumption.
Scope of government activity
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The extent to which the state should assume the responsibility of supplying goods to the economy
can be discussed from two angles:
i.
Theoretical angle
Generally, the government should provide either pure public goods and to some extent impure
public goods.
1. Pure Public goods
The provision of pure public goods should be left entirely to the public sector. If the task is left in
the hands of the private sector then the system is likely to suffer from inefficiency on account of
the following reasons:
i.
Market mechanism can supply only a priced good. This would automatically enforce
the principal of exclusion to its use. For public goods enforcing of the principle will be
very costly to implement.
ii.
To the extent that some of the external effects of public goods cannot be priced there will
be a divergence between private and social marginal costs of products. The supply of
the goods therefore would not be at an optimum level. It would either be more or less.
iii. The market mechanism fails in the case of pure public goods since the users cannot be
forced to reveal their demand preferences. The suppliers are faced with the problem of
free riders.
2. Quasi-Public goods (impure public goods)
It would be noticed that it is highly difficult to come across goods which fully satisfy all the
characteristics of pure public goods. This is to say that most goods possess elements of both public
awareness and private awareness in them. Conversely, the role of the state should be limited to
those goods which have more of ‘publicness’ in them while predominantly ‘private’ ones should
be left to the private sector and the market mechanism.
3. Merit Goods
The provision of merit goods helps the economy in attaining a high level of efficiency and
contributes to achieving of basic objectives of the society. For example, if the provision of
educating the children will have to be borne by their guardians, this would deprive many brilliant
students of educational opportunities. Similarly, precious lives may be lost if health services are
left to the forces of the market only. The state therefore should supplement their availability.
Through provision of subsidies, the government ensures that external benefits do not involve
interference with individual choice-but rather permit such choices to be made more efficiently.
This justifies the provision of such merit goods as public health and education
ii.
Historical Angle
Before the advent of modern capitalism, the state used to intervene in economic activities of the
society to a substantial extent. However, with time, it became apparent that the provision of certain
goods necessitated productive efficiency which required the guidance of a market-guided private
sector. Adam Smith, through the Laissez-faire philosophy, believed that the market was able to
generate efficient signals for economic units.
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Government Failures and Market Failures
All real-world markets in some way fail. Market failures should not automatically call for
government intervention because governments fail too.
What is Government failure? This occurs when the government intervention in the market to
improve the market failure actually makes the situation worse Intervention. Government failure
occurs when an intervention leads to a deeper market failure or even worse a new failure may arise.
In other words – intervention creates further inefficiencies, a misallocation of resources and a loss
of economic and social welfare. Examples of government intervention policies that results to
failure;
1. Policies may have damaging long-term consequences
2. Policies may be ineffective in meeting their aims
3. Policies may create more losers than winners- Policies may create increase inequalities of
income and wealth
What are the Reasons for Government Failures?
 Government doesn’t have an incentive to correct the problem
 Government doesn’t have enough information to deal with the problem
 Intervention in markets is almost always more complicated than it initially seems
 The bureaucratic nature of government intervention does not allow fine-tuning
 Government intervention leads to more government intervention.
What are some of the Causes of Government Failure?
 Political self interest- Government influenced by influential political through lobbying.
Farm support policies, the drinks industry, transport lobby
 Poor value for money results in low productivity or high waste makes spending less
effective- Investment on IT projects in the NHS, poor record of public projects.
 Policy short- termism- Governments often looking for a “quick fix” solution for example.
Road widening to reduce congestion.
 Regulatory capture- When Govt agency operates in favour of producers. Self-regulation on
alcohol prices.
 Conflicting objectives- One policy objective might conflict with another. Minimum carbon
price could damage country competitiveness.
 Bureaucracy and Costs of enforcement may hurt enterprise.
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Evaluation on Government Intervention
1. Value judgements: Many people want a particular intervention because of their own vested
interests.
2. Changing prices to change incentives and behaviour.
3. Social science: The effects of intervention cannot be forecast with great accuracy – people’s
behaviour is subject to change
4. Combinations of policies: One single intervention is unlikely to produce a solution to deeprooted problems – build a variety of policy options into your discussion e.g. policies that work on
market demand and market supply
5. The power of markets: Market forces can be powerful in finding profitable solutions to problems
6. The ‘law of unintended consequences’: Intervention does not always work in the way in which
it was intended or the way in which economic theory predicts it should.
Summary guide for evaluating government intervention in markets
How significant is the market failure ? ( consequences)
Can the market/price mechanism find some solutions?
What are the likely consequences of not intervening?
How effective is an intervention? ( i.e consider alternatives)
Consider the potential for one or more government failures
Which one work best – market based or regulatory ( command and control approaches)
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NATION’S FISCAL ARCHITECTURE
For the purpose of economic stability and growth the government adopt budgetary
and fiscal measures. The aspect of budgetary and fiscal are:
Budget- this is an annual statement tabled before the national assembly by the
minister of finance which consist of revenue and expenditure estimates for a
particular fiscal year.
Quantitative Classification of Budgets
1. Surplus Budget
This is arrived at when the total estimated revenue is greater than the total estimated expenditure.
While some ministries of government are revenue centers, generating more revenue than the cost
they incur, most government ministries are cost centers; incurring more cost than the revenue they
generate. The total of the estimated revenues of the relevant ministries and the total of the estimated
expenditures of all the ministries are aggregated and compared when the budgets are approved.
2. Deficit Budget
This is the reverse of the surplus budget, that is, it is arrived at where the total anticipated
expenditure is greater than the total anticipated revenue.
3. A Balanced Budget
This is arrived at where the total estimated expenditure is equal to the total estimated revenue or
when the difference between the two is insignificant.
Types of Budgets
1. Short-term budget
This relates to current conditions and it usually covers a period of one year. Even annual budgets
are in turn broken down into quarterly, monthly, fortnightly or weekly budgets for control
purposes, as management may wish to take corrective actions before a situation gets out of hand.
A widely used variant of the short-term annual budget is the rolling or continuous budget. The
budget is formulated initially for a period of one year or more and is broken down into smaller
periods. As each month, quarter or week passes, two actions take place. Firstly, a budget for the
corresponding period of the following year is prepared, ensuring that a short-term budget is always
in existence for the immediate future of twelve (12) months; and secondly, the budget is to be
revised in the light of the results of the period which has elapsed, thus ensuring that the current
budget is revised constantly and kept up-to-date.
2. Long-term budget
This relates to the development of the organization or its business over many years. It is usually
drawn up in any general terms which cover the nature of the business, its position in the industry,
the expected level of inflation and its impact on the business. A period of between three to ten
years may be appropriate for a long term budget. Matters such as capital assets purchase and long
term finance between debt and equity are considered in long term budgeting decisions.
3. Medium-term budget
This is a budget that is formulated to relate to any financial or non-financial budgets that may cover
the period of between one to five years, with a period of thirteen (13) months as the floor and a
period of fifty-nine months as the ceiling. The categorization is not popular, as long-term budget
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is readily serving its purpose.
Activity Classification of Budgets
1. Operating Budgets:
These are budgets that reflect day-to-day activities or operations of an organisation. This category
deals with items of manufacturing, trading and profit and loss accounts like material purchases,
labour cost, production and overhead, sales, purchases, ending inventory and opening inventory
budgets. It also deals with revenue or incomes budgets and expenses or expenditure budgets.
Operating budget is synonymous with recurrent expenditure budget of the government’s financial
year.
2. Financial Budget
This budget relates to financing of assets and generally indicates cash inflow and outflow. Capital
budgeting is part of financial budget. This category is the budget to be prepared on the funds to be
generating through different sources for the financing of various projects. The budget indicates
ownership of assets and insurance of liabilities and, so it gives the information which would enable
a budgeted balance sheet to be prepared.
Fiscal policy are modern thoughts in economics and they can be said to be a
combination of those deliberate changes in the government expenditure programs
government revenue programs and debt management policies to bring about
economic development.
These policies are concerned with determining the type, timing and procedures that
should be followed in making govt expenditures, obtaining government revenue and
when sourcing for debt.
Objectives of fiscal policy are:
 Achievement of desirable price levels
 Achievement of desirable employment levels
 Achievement of desirable development levels
 Achievement of wealth distribution
The main instruments of a fiscal policy include: \
1. Public revenue
2. Public expenditure
3. Public debt
PUBLIC REVENUE
INTRODUCTION
Dr. Dalton makes a distinction between public receipts and public revenue. Public income, in the
broad sense, is referred to as public receipts. Income received by the government from all sources
is known as public receipts. Public income, in the narrow sense, is called public revenue, which
excludes “receipts from public borrowings and from the sale of public assets, The main sources of
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public revenue are taxes and prices, while public receipts also include receipts from public
enterprises, receipts from special assessments, and income from the issue of Paper money ( deficit
financing), and voluntary gifts.
Sources of public income
i) Taxes
Taxes are the most important source of government income. Dr. Dalton defined a tax as “a
compulsory contribution imposed by a public authority, irrespective of the exact amount of
service rendered to the taxpayer in return.” According to Prof. Seligman, a tax is “a
compulsory contribution from a Person to the government to defray (meet/cover/pay) the
expenses incurred in the common interest of all, without reference to special benefits
conferred.”
These definitions point towards three characteristics of a tax.
 First, it is a compulsory contribution imposed by the government on the people residing
in the country. Since it is a compulsory payment, a person who refuses to pay a tax is
liable to punishment. But a tax is to be paid only by those who come under its jurisdiction.
Similarly, persons who buy a commodity, which carries a tax on it, pay the tax while
others do not.
 Second, a tax is a payment made by the taxpayers, which is used by the government for
the benefit of all the citizens. The state uses the revenue collected from taxes for providing
hospitals, schools, and public utility services etc. which benefit all people.
 Third, a tax is not levied in return for any specific service rendered by the government
to the taxpayer. An individual cannot ask for any special benefit from the state in return
for the tax paid by him. In the words of Prof. Tausig, ‘’the essence of a tax... is the absence
of a direct quid pro quo between the taxpayer and the public authority.” It implies that
the taxpayer cannot claim something equivalent to the tax paid (quid pro quo) from the
government.
ii) Revenue from Public Enterprises.
 Revenues received by the government from public enterprises are also an important
source of public income. The Central Governments and local bodies operate commercial
enterprises and public utilities. The surpluses obtained by selling their goods and services
are called prices. Such, enterprises may be run on monopolistic or/and competitive basis.
If the state has a monopoly of water, electricity, or city transport, the price charged in
excess of normal cost of production is like a tax. In case of competitive selling, whatever
public undertakings earn above normal profits are surpluses, which do not have any
Element of compulsion on the part of buyers of those goods and services.
iii) Fees
 These are amounts received by the government for rendering certain goods and services
as a price paid to receive official permission to do something e.g. trade license fees, import
license fees, etc.
 A person who wants to benefit from a particular service rendered by the public authority
is charged a fee. The service may be legal for which a person has to pay a court fee,
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registration fee of property or marriage, payment of fee for a competitive examination,
etc. Like prices, there is an element of quid pro quo in the payment of fees. But if the cost
of performing a service is less than the fee charged, then it is in the nature of a tax. A
license fee is different from a fee. A fee is paid for some service actually rendered while a
license fee is charged by a public authority to grant permission, to a person to perform
service by himself. The aim is to exercise state control or regulation over the various
activities. Persons wishing to open chemist shops and wine shops, to drive a scooter or
any other vehicle, and to keep a gun or a revolver has to obtain a license from an
appropriate authority.
iv) Fines and penalties
These are not imposed to collect revenue but to punish the people for the infringement of state
laws. They, therefore, resemble taxes only in that they are compulsory payments without any quid
pro quo.
.
v) Gifts and Grants Gifts
These are voluntary contributions made by individuals and societies to the government for relief
work in the event of an earthquake, flood, famine, or war. So they are not in the nature of a tax.
Grants are given by the Central government to the Local authorities or provincial governments to
meet the cost of specific projects or schemes in public interest, such as the provision for drinking
water, drainage, irrigation, roads, etc. Besides, there are unconditional grants, which can be utilized
by the recipient authority in any manner it likes for purposes of development. Grants are also made
by one country to another at governmental level. They are for reconstruction, for development, or
for war. Underdeveloped countries are receiving grants for economic development from the
developed nations of the world. But all grants are voluntary gifts and are thus very uncertain source
of revenue for the government.
vi) State Property
The government is a custodian of state property e.g. land, forests, mines, national parks, etc. The
income that arises from such property is also another source of public revenue. The income will
arise from payment of rents, royalties, or sale of produce.
vii) Prices
Prices are those amounts which are received by the central or local authority for commercial
services e.g. railway fare, postage and revenue stamps, telephone charges, radio and television
advertisement etc PURPOSE AND
viii) Internal Borrowing
The government usually raise revenue through issue of treasury bills and treasury bonds in the
local market.
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External borrowing
This is done from foreign governments and international financial institutions such as World Bank
and International Monetary Fund (IMF).
TAXATION
This is the easiest and the most convenient and productive source of government revenue.
CHARACTERISTICS OF A GOOD TAX SYSTEM
Public expenditure has been continuously increasing with the expansion of the functions of
modem governments. Since the tax revenue is the easiest and the most convenient and productive
source of income, governments are inclined to use more of this rather than the non-tax revenue. It
is, therefore, instructive to study the characteristics of a good tax system.
1. Equitable.
The tax system should meet the canon of equity. Every person should be taxed according to his
ability, that is, the rich should pay more and the poor less and therefore taxes should be progressive
in nature.
2. Certain.
A good tax system should be based on the cannon of certainty. “The time of payment, the manner
of payment, the quantity to be paid, ought all to be clear and plain to the contributor and to every
other person.” The tax, which every individual is required to pay, should be certain and not
arbitrary so that he is not left to the whims of the tax officials
3. Convenient.
The tax system should satisfy the canon of convenience, i.e, the time and mode of payment of the
tax should be so fixed that it is not, inconvenient for the taxpayer.
4. Economical.
A good tax system should be economical to the government in the sense that the cost of collection
of taxes should be small in proportion to the revenue from them.
5. Productive.
The tax system should be such as to bring in sufficient revenue in the exchequer. In other words,
it should be productive.
6. Elastic.
A good tax system should be sufficiently elastic so that the tax revenue may be increased or
decreased according to the requirements of the state.
7. Simple.
The tax system should be simple to understand and administer.
8. Multiple Taxes.
A good tax system should have multiple taxes rather than a single tax. According to Dalton, “It is
best to rely on a few substantial taxes for the bulk of the tax revenue.”
9. Income-Elastic.
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It should be income-elastic. As national income increases, the share of taxation in national income
should rise more than proportionately.
10. Least Bad Economic Effects.
According to Dr. Dalton; “The best system of taxation from the economic point of view is that
which has the best, or the least bad economic effects.” It should not adversely affect production
through effects on ability and desire to work, save and invest.
11. Reduce Inequalities.
According to Wagner, a good tax system should reduce the inequality of incomes.
12. Balanced.
The tax system should be a balanced one in which progressive, proportional, direct and indirect
taxes should be properly distributed.
Conclusion
The major problem is to find a sufficient number of taxes that may satisfy these criteria. But
treasury officials can no more find one tax that pre-eminently meets all requirements than an
automobile engineer can design a car that is simultaneously fastest, safest and cheapest.
Purposes of tax
1. Raising Revenue-the main purpose of imposing taxes is to raise government income
or revenue. Taxes are the major sources of government revenue. The government
needs such revenue to perform its activities.
2. Economic Stability- taxes are also imposed to maintain economic stability in a country.
In theory, during inflation, the government imposes more taxes in order to discourage the
unnecessary expenditure of the individuals. On the other hand, during deflation, the taxes
are reduced in order to encourage individuals to spend more money on goods and services.
The increase and decrease in taxes helps to check the big fluctuations in the prices of goods
and services and thus maintain the economic stability.
3. Protection Policy- where a government has a policy of protecting some industries or
commodities produced in a country, taxes may be imposed to implement such a policy.
Heavy taxes are therefore imposed on commodities imported from other countries which
compete with local commodities thus making them expensive. The consumers are therefore
encouraged to buy the locally produced and low priced goods and services.
4. Social Welfare- some commodities such as wines, spirits, beer, cigarettes, etc. are harmful
to human health. To discourage wide consumption of these harmful commodities, taxes are
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imposed to make the commodities more expensive and therefore out of reach of as many
people as possible.
5. Fair Distribution of Income-Taxes can be imposed which aim to achieve equality in the
distribution of national income. The rich are taxed at a higher rate and the amounts obtained
are spent on increasing the welfare of the poor. That way, the taxes help to achieve a fair
distribution of income in a country.
6. Allocation of Resources -taxes can be used to achieve reasonable allocation of resources
in a country for optimum utilization of those resources. The amounts collected from taxes
are used to subsidize or finance more productive projects ignored by private investors. The
government may also remove taxes on some industries or impose low rates of taxes to
encourage allocation of resources in that direction.
7. Increase in Employment- funds collected from taxes can be used on public works
programmes like roads, drainage, and other public buildings. If manual labour is used to
complete these programmes, more employment opportunities are created
Kinds/types of taxes administered in Kenya
a) Income tax — this is tax imposed on annual gains or profits earned by individuals, limited
companies, business and other organizations.
PAYE
for employed persons and
Corporation tax for companies.
b) Value added tax (V.A.T.) — this is tax imposed on sale of commodities and services
introduced in Kenya with effect from 1.1.90. It was previously called Sales tax — this is
tax imposed on sale of commodities which was abolished in Kenya on 31.12.89 and
replaced with value added tax.
c) Turnover Tax — is charged on income or receipts from business by taxable persons of a
turnover between Sh. 500,000 and Sh. 5 million within a period of 12 months with effect
from 1.1.2008.
d) Customs and excise duty — this is tax imposed on import or export of commodities. It
targets specific commodities, for example, luxuries and commodities that are detrimental
to health.
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e) Stamp duty — this is tax that is aimed at legitimizing transactions. It is imposed on
increase of share capital, transfer of shares, mortgages, charges, the transfer of property
among others.
f) Monthly Rental income taxes- paid by land lords on rental income.
g) Capital gain taxCLASSFICATION OF TAXES OF TAXES
Basis of tax classifications
1. Impact of tax-It means on who tax is imposed and who has to bear the burden of tax. Taxes
under this may be direct or indirect.
2. Base of tax-. The base is the item to be taxed. It is the income being taxed in the case of
income tax, the value of property in the case of a property tax, and. the value of goods sold
in the case of a sales tax tax base is the object upon which tax is levied and to which tax
rate is applied. Taxes may be income( base is income), export(base is value of goods
exported) and import(base is value of goods imported)
3. Rates of taxes-This is the percentage of tax base to be taken .it may include progressive,
proportional, regressive tax or digressive tax.
Progressive, Proportional and Regressive Taxes
Taxes are levied by the government on the basis of three major classes of tax rates. They are
progressive, proportional and regressive. In order to understand them, it is essential to know how
these three types of tax rates differ from each other on the basis of the tax base.
Proportional Tax
A proportional tax is one whose percentage rate remains the same as the tax base increases. As
a result, the amount of tax paid is proportional to the tax base. If the tax rate is constant at 30%,
every person shall have to pay income tax at this rate as his/her income Tax Amount increases.
Proportional tax system has the following merits.
1. Simple.
It is very simple and every person can understand it without any difficulty. It can be easily
administered because there are no complicated tax slabs.
2. Easy.
It is easy for every person to calculate the amount of tax he is required to pay.
3. No Change in Income Distribution.
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It does not affect the pattern of income distribution in the country because every person pays the
same rate’ of tax
4. Neutralizing Effects.
Proportional taxation has neutralizing effects on savings and incentives.
5. Non-disturbing.
This tax system disturbs the economy as little as possible because every person contributes as
nearly as possible in proportion to his ability to pay.
According to Adam smith Proportional tax system possesses the following demerits.
1. Inequitable.
This tax system is inequitable because it adversely affects the low income groups and favours the
high income groups. This is because with the increase in the income of a person, the marginal
utility (MU) of income diminishes for him. As such, the MU of money for low income groups is
high and low for high income groups. So when both income groups are taxed at the same rate,
persons belonging to the low income groups make a greater sacrifice than those in the high income
groups. Thus the proportional tax system is inequitable.
2. Increases Inequalities.
It increases inequalities of income and wealth instead of reducing them because the gap between
the high income and low income groups widens. This is the result of the same tax rate for the two
income groups.
3. Less Productive.
This tax system is not sufficiently productive in the sense that it does not bring enough revenue
into the public exchequer due to a constant tax rate.
4. Bad Effects on the Economy.
By taxing the high and low income groups at the same rate, this tax system proportionately takes
away a larger percentage of the income of low income groups. As a result, the consumption
standard of such groups falls, thereby leading to their weak health and consequently to low
productivity. This adversely affects the country’s productive resources.
A. Progressive Tax
A progressive tax is one whose percentage rate increases as the tax base increases. In other
words, as the income of a person increases, the tax rate also increases gradually, and vice versa. A
progressive tax is graduated so that a person with a higher income pays a greater percentage in tax
than a person with a lower income.
Progressive tax system has the following advantages:
1. Ability to Pay.
Progressive taxes are based on the principle of ability to pay. According to the progressive tax
system, as a person’s income increases, he is required to pay more tax. This is because the MU of
income falls as income increases. Therefore, the rich should pay more because their ability to pay
increases with the rise in their incomes. But for a person with low income, the MU of income
increases as his income rises because he needs more money to satisfy his unsatisfied wants. By
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levying high tax rates on higher incomes and low tax rates on lower incomes, the progressive tax
system satisfies the principle of ability to pay.
2. Productive
Progressive taxation is highly productive because it yields more revenue to the government. The
government can increase its income by substantially raising the tax rate to meet its increasing
expenditure now-a-days.
3. Elastic
This tax system is elastic because the government can change the tax rates whenever it needs extra
revenue or wants to give relief to low income groups.
4. Economical
Progressive taxation is economical because the cost of collection of taxes does not increase when
the tax rates are increased. It is occasionally that the cost of collection rises less than the revenue
From the tax as the tax rate is increased, depending on the nature of the tax, as in the case of sales
tax.
5. Income Equality
It brings equality of income and wealth in the country when the rich are taxed at higher rates and
the low income groups at lower rates or even are exempted.
6. Social Justice
When the rich are taxed heavily and the low income groups are exempted from paying taxes,
progressive taxation promotes social justice in the country.
7. Equitable
Progressive taxes are equitable. They require proportional sacrifice on the part of taxpayers. The
high income groups bear the heaviest burden and the low income groups’ low burden of such taxes.
8. Economic Stability
Progressive taxation helps economic stability in the country. By reducing the tax rates during a
recession or depression, the government provides relief to the taxpayers so that they may increase
their demand for goods. As a result, investment is encouraged. On the other hand, by raising the
tax rates during a boom, the government reduces the purchasing power of the taxpayers.
Consequently, the demand for goods and investment are discouraged. Thus this tax system helps
in bringing economic stability in the economy.
9. Better Use of Resources
Progressive taxation helps in making better use of country productive resources. The high income
groups mostly indulge in conspicuous consumption and thus waste their incomes. By taxing luxury
goods and the incomes of the rich heavily, the government can prevent them from wasteful
expenditures and make better use of the country’s productive resources.
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Demerits of Progressive Taxes
1. Faulty Basis
Progressive taxation is based on the principle of diminishing MU of income which is faulty. Utility
is subjective and it cannot be measured and compared in terms of money. Therefore, it is not right
to have a progressive tax system based on subjective utility. Despite this faulty assumption of
diminishing marginal utility of income, the progressive tax system is working satisfactorily in
every country.
2. Arbitrary
Progressive taxes are arbitrary because there is no scientific or standard method to fix the rate of
progression. There can be infinite scales of progression depending on the whims of the finance
secretary or the finance minister. No doubt, there is no method to fix the rate of progression. But
there are legislators to check the arbitrariness of the finance department in every country.
3. Discourages Capital Formation
Progressive taxation adversely affects saving, investment and capital formation. It is the high
income groups who are the main source of savings in a country. Heavy taxes on them discourage
saving and investment and thus hamper trade and industry in the country.
4. Unjustified
Critics point out that progressive taxation is an unjustified method. People become rich through
thrift and hard work. Those who are extravagant and lazy remain poor. Taxing the high income
groups at high rates is unjustified. But this criticism is not valid because it is not only through thrift
and hard work that people become rich. There are other factors like entrepreneurial ability,
favorable economic environment, etc. that make people wealthy. Similarly, extravagance and
Laziness do not make people poor. Poverty may be the result of economic and social factors.
5. Tax Evasion
Progressive taxation leads to tax evasion and avoidance. People, who are taxed heavily, try to
evade taxes by maintaining false accounts and submitting false statements to income authorities.
They also try to avoid taxes by finding loopholes in the tax laws. This is no valid argument because
all types of taxes can be avoided and evaded. Payment of taxes depends on the social and tax
consciousness of the people.
B. Regressive Tax
A regressive tax is one whose percentage rate decreases as the tax base Tax Base increases. In
other words, as the income of a person rises, the tax rate decreases. A high income person pays
less tax than a low-income person, in proportion. to his high income. Thus regressive tax is just
the opposite of progressive taxation.
4. Direct and Indirect Taxes·
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A direct tax is really paid by the person on whom it is legally’ imposed, while an indirect tax is
imposed on one person, but paid partly or wholly by another, owing to a consequential change in
the terms of some contract or bargain between them. Thus an indirect tax is conceived as one which
can be shifted or passed on; a direct tax as one which cannot be shifted or passed on. John Stuart
Mill defined a direct tax as one which is “demanded from the very person who it” is intended or
desired should pay it” On the other hand, an indirect tax is defined as one which is “demanded
from one person in the expectation and intention that he shall indemnify himself at the expense of
another.” This is the administrator’s or government’s viewpoint which may create confusion. The
government imposes a commodity tax, which is an indirect tax in the expectation that it will be
shifted. But if the producer is unable to shift the tax on to the sellers, it is a direct tax.
Merits of Direct Taxes
Direct taxes possess the following merits:
1. Equitable
Direct taxes are based on the canon of equity. Their burden is equitably distributed as they are
progressive in nature. As the income of a person increases, the rate of income tax also increases.
so all direct taxes fall heavily on the people whose income and wealth increase. The poor are not
affected by such taxes.
2. Certain
Direct taxes satisfy the canon of certainty. The taxpayer is certain as to the time and manner of
payment, and the amount to be paid in the case of these taxes. Similarly, the government is also
Certain as to the amount of money it shall receive from these taxes.
3. Economical
These taxes also satisfy the canon of economy. The cost of collection of direct taxes is low. In the
case of income tax, it is deducted at the source from the salaried persons. The assessments of
wealth, incomes ,inheritance gifts etc can be made by same officer .no separate staff is needed for
each. Such taxes are also economical to the taxpayers who make payments direct into the treasury.
4. Elastic
Direct taxes are flexible and thus satisfy the canon of elasticity. The government can increase or
decrease the rates of direct taxes according to the requirements of the economy. In case of war,
natural calamities, or emergency, the state can raise the rates of these taxes in order to have larger
tax revenue. During a depression, it can reduce their rates considerably.
5. Simple
Direct taxes are simple and easy to understand
6. Desirable
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These taxes do not involve general opposition from the public because they are paid by those
persons or firms who come under the jurisdiction of income tax or corporation tax. Thus they are
based on the canon of desirability.
7. Reduce Inequalities
These taxes help reduce income and wealth inequalities because of their progressive nature. The
rich are taxed heavily through income tax, wealth tax, expenditure tax, excess profit tax, gift
tax”etc. so long as they are alive; and through inheritance taxes or death duties when they die. The
poor and the income groups which lie below the minimum tax limit are exempted from these taxes.
8. Civic Consciousness
Direct taxes inculcate civic consciousness among the taxpayers. They are conscious that they are
paying taxes to the government and take interest in the activities of the state as to whether public
expenditure is incurred on public welfare or not. Such civic consciousness puts a check on the
wastage of public expenditure in a democratic country.
Demerits of Direct Taxes
1. Unpopular.
Direct taxes pinch the taxpayers because they have to pay them directly out of their incomes or
salaries. They are, therefore, unpopular.
2. Inconvenient.
These taxes are inconvenient in nature because traders, businessmen, producers, etc. have to
comply with a number of formalities relating to their sources of income and expenditure incurred
in earning that income. Often the details are incomplete and the various Sections of the Acts so
complicated that the taxpayers have to take the help of income tax experts by making them
payments. Moreover, these taxes are payable in advance and in lump sum, except in the case of
salaried persons. Hence they are inconvenient.
3. Arbitrary.
Direct taxes possess an element of arbitrariness in them. They leave much to the discretion of the
taxation authorities in fixing the rates of taxation and in interpreting them.
4. Evasion.
Since direct taxes pinch every taxpayer, he tries to evade them by filling wrong returns and even
takes the help of income tax experts: Thus such taxes cultivate dishonesty and there is loss of
revenue to the state.
5. Not Imposed on All.
Direct taxes are not imposed on all income groups. Low income groups do not come under the
purview of these taxes. Such groups, therefore, do not contribute anything to the state exchequer
through direct taxation.
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6. Discourage Saving and Investment.
Direct taxes adversely affect saving and investment. When people know that with the increase in
their incomes and wealth, they will have to pay a large portion in the-form of taxes, they are
reluctant to save and invest more. This adversely affects the will to work, save and invest.
7. Discourage Production.
Corporation taxes discourage those industries and firms which produce essential goods.
Merits of Indirect Taxes
1. Convenient.
Indirect taxes are less inconvenient and less burdensome. They are paid only when a commodity
or a service is bought. So they are~ paid in small amounts rather than in lump sum. Since these
taxes are included in the prices of commodities, buyers do not feel the burden of these taxes. Such
taxes are like sugar-coated pills.
2. Wide Coverage.
These taxes reach the pockets of all income groups low, middle and high. They are levied on
necessaries, comforts, and luxuries. Thus they have a wide coverage, and every consumer pays to
the state exchequer according to his ability to pay. Thus they are equitable.
3. Elastic.
Indirect taxes are also elastic in nature. The government can reduce or increase the rates of, say,
excise duties, or custom duties according to its requirements. But care should be taken in not
imposing high rates on necessaries which are mostly consumed by the poor.
4. Economical.
These taxes are economical in the sense that they involve little cost of collection because the
producers and sellers themselves deposit them with the government.
5. Diversity.
Indirect taxes satisfy the canon of diversity. They can be levied on a variety of commodities and
services. So the government can be sure of continuous and sufficient revenue, even if it is required
to reduce the rates of taxes on certain commodities due to the fall in their demand.
6. Less Evasion.
There is less possibility of evasion in the case of indirect taxes because they are included in the
prices of commodities. As these taxes are shiftable on the ultimate consumers, the producers, the
wholesalers, and the retailers do not mind paying them. The consumers can evade them only if
they decide not to buy the taxed commodities. However, these taxes are generally evaded by
producers when they sell their products to the wholesalers and the
retailers without entering the goods in their stocks and without issuing a bill cash receipt for the
same.
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7. Check the Consumption of Harmful Goods.
Indirect taxes have the great merit of checking the consumption of harmful goods like wine,
cigarettes and other intoxicants. The state levies heavy duties on such articles of consumption
which are injurious to health and efficiency of the people. As a result, their prices rise and their
consumption is reduced. The state also earns substantial revenue.
8. Powerful Tool of Economic Policies.
Indirect taxes can be used as a powerful tool for implementing economic policies by the
government. If the government wants to protect domestic industries from foreign competition, it
can levy heavy import duties. This will help develop domestic industries. If the government wants
to encourage one industry on priority basis, it may not levy any taxes on its products but continue
the taxes imposed on other industries. The government may do so in order to encourage a particular
technology or employment in a particular industry.
Demerits of Indirect Taxes
1. Uncertain Revenue.
The revenue from indirect taxes is uncertain because it is not possible to accurately estimate the
effect of such taxes on the demand for products. If a heavy excise duty is levied on some luxury
article, its price will rise. Since the demand for a luxury good is elastic, its sales may be adversely
affected by a fall in demand and the state revenue may actually decline.
2. Uneconomical.
These taxes are uneconomical in that the cost of collection to the state is heavy. The state has to
appoint inspectors to check the accounts and stocks of producers, wholesalers, and retailers in
order to find out whether they are paying taxes or not. Thus they are more expensive than direct
taxes.
3. Bad Effect on Production and Employment.
Sometimes, these taxes adversely affect production of commodities, and even employment. When
the price of a commodity increases with the levy of a tax, its demand falls (if it happens to be a
commodity with elastic demand). As a result, its production falls, and so does employment
4. Feed Inflation.
Another demerit of indirect taxes is that they feed inflation. Imposition of these taxes tends to raise
the prices of commodities, thereby leading to higher costs, to higher wages, and again to higher
prices. Thus price-wage cost spiral sets in the economy.
5. Lack of Civic Consciousness.
A person who buys a commodity does not know that he is paying a tax to the government in the
price of the commodity. Therefore, such taxes do not inculcate civic consciousness among .the
majority of taxpayers who are ignorant of the fact that they are contributing something to the state
exchequer.
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CANONS OF TAXATION
1. The Canon of Equality
The canon of equality, equity or justice is the most important canon of taxation. Smith explanation
it thus: “The subjects of every state ought to contribute towards the support of the government, as
nearly as possible, in proportion to their respective abilities, that is, in proportion to the revenue
which they respectively enjoy under the protection of the State.” It means that every person should
pay the tax according to his ability and not the same amount. It also means that everybody should
not pay at the same rate. Rather, every taxpayer should pay the tax in proportion to his income.
The rich should pay more and at a higher rate than the other person whose income is less. Thus
this canon implies equality of sacrifice or ability to pay the tax in proportion to the income of the
taxpayer.
2. The Canon of Certainty
According to Smith, there should be certainty in taxation because uncertainty breeds corruption.
By the canon of certainty he means that “the tax which each individual is bound to pay ought to
be certain, and not arbitrary. The time of payment, the manner of payment, the quantity to be paid
ought all to be clear and plain to the contributor and to every other person.” Thus this canon
requires that there should be no element of arbitrariness in a tax. It should be clear to every taxpayer
as to what, when, and where the tax is to be paid. Nothing should be left to the discretion of the
income tax department. Certainty also means that the state should also be certain about the amount
of tax revenue and the time when it is expected to flow in the exchequer.
3. The Canon of Convenience
This canon lays down that both the time and manner of payment should be convenient to the
taxpayer. In the words of Smith, “Every tax ought to be levied at the time or in the manner in
which it is most likely to be convenient for the contributor to pay. Similarly, the payment of sales
tax and excise duty by the consumer is also convenient because he pays these taxes when he buys
commodities and at a time when he has the means to buy. The manner of payment is very
convenient to him because these taxes are included in the prices of commodities.
4. The Canon of Economy.
Every tax should satisfy the canon of economy in two ways. First, it should be economical for the
state to collect it. If the cost of collection in the form of salaries of tax officials is more than what
the tax brings as revenue, such a tax is uneconomical, and hence it should not be levied. Second,
it should be economical to the taxpayer. It means that he should have sufficient money left with
him after paying the tax. A very heavy tax on incomes will discourage saving and investment, and
thus adversely affect the productive capacity of the community. Smith states this canon in these
words: “Every tax ought to be so contrived as both to take out and to keep out of the pockets of
the people as little as possible, over and above what it brings into the public treasury of the state.”
5. The Canon of Productivity
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According to this canon, a tax should be productive in the sense that it should bring large revenue
which should be adequate for the government. But it does not mean that in its efforts to raise more
revenue, the government should tax the people heavily. Such an effort would adversely affect the
productive capacity of the economy. Further, this canon implies that one tax which brings large
revenue is better than a number of taxes which bring small revenue. Many taxes may not be
productive. They may also be uneconomical.
6. The Canon of Elasticity
This canon is closely related to that of productivity. The canon of elasticity requires that the
government should be able to raise the rates of taxes when it is in need of more revenue. In other
Words, taxes should be elastic. The best example is excise duties. They can be levied on any
number of commodities and their rates can be increased every year in order to raise more revenue.
But care has to be taken that the rates of excise duties should not be so raised that they may
encourage inflationary pressures in the economy.
7. The Canon of Flexibility
Flexibility in taxation is different from elasticity. Flexibility means that there should be no rigidity
in taxation. The tax system can be changed to meet the revenue requirements of the State. On the
other hand, elasticity in taxation means that the revenues can be increased under the prevailing tax
system. But there cannot be any elasticity in taxation without flexibility because some change is
required in the rates and structure of taxes if the state wants to increase revenue.
8. The Canon of Simplicity
The tax system should be simple, plain and intelligible to the common taxpayer. The tax system
should not be complicated. It should be simple to understand as to how is it to be calculated and
how much is it to be paid. The form/forms to be filled up for calculation and payment of a tax
should be simple and intelligible to the taxpayer. This canon is essential in order to avoid
corruption and oppression on the part of the tax department.
9. The Canon of Diversity
There should be diversity or variety in taxation. A single or a few taxes would neither meet the
revenue requirements of the state nor satisfy the canon of equity. There should, therefore, be a
variety of taxes so that all citizens should contribute towards the state revenues according to their
ability to pay. There should be a variety of direct and indirect taxes. But a large multiplicity of
taxes will be difficult to administer and hence uneconomical.
TAX SHIFTING
This is the process of transferring taxes. It is the transfer of the burden of a tax from the person on
whom it is legally imposed to another person. A tax may be shifted either forward or backward.
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1. Forward shifting-A tax is shifted forward when the producer of a commodity
transfers the money burden of the tax on the wholesaler, the wholesaler on the retailer
and the retailer to the final consumer through increased price
2. Backward Shifting-Backward shifting refers to shifting the money burden of the tax on
the suppliers of factors of Production by forcing them to accept lower prices for their
services, such as reducing the wages of the laborers
Illustration
New KCC Ltd. buys milk from dairy farmers at Sh 5 per litre and after processing sells it at Sh
10. Assuming that a tax of 20% is imposed on every litre of milk sold, demonstrate how the tax
can be shifted?
Possible outcomes
1. If New KCC Ltd. bears the whole tax i.e. it does not change the buying price or the
selling price, there will be no tax shifting.
2. If New KCC Ltd. transfers the whole tax to the consumers by raising the selling price by
Sh 2 to Sh 12 i.e. 20% of Sh 10, it is referred to as forward shifting.
3. New KCC Ltd. could transfer the whole burden to dairy farmers so that the buying price
of milk is lowered by Sh 2 to Sh 3. This is referred to as backward shifting.
4. The tax could be shifted partly forward to the consumers and partly backwards to the
farmers. New KCC Ltd. could bear part of the tax shift forward partly and shift
backwards partly.
TAX INCIDENCE
The problem of incidence of taxation is related to the important question: who ultimately pays a
tax? Or, who bears the Money burden of a tax? The incidence of a tax involves the process of
transfer from the person on whom the tax is imposed initially to the ultimate taxpayer who bears
the money burden of the tax. The process of transfer of a tax is known as the shifting of the tax,
30
while the settlement of the burden on the ultimate taxpayer is called the incidence of the tax. The
incidence of the tax is on the consumer who ultimately bears the money burden of the tax.
The incidence of a tax is the direct money burden of the tax. It deals with who ultimately pays
the tax.
The Importance of Tax Incidence
1. It ensures that there is an equitable distribution of the tax burden according to who pays
the tax.
2. The government needs to know who ultimately bears the money burden of any tax which
shows the final resting point of any tax.
3. It helps identify reactions and repercussions of any tax.
Effects of a tax refer to its real burden both direct and indirect e.g. sacrifice of economic welfare
or reduced consumption of a commodity.
N/B: Incidence of a tax leads to the effect of the tax. It is the incidence of a tax that may be shifted.
EFFECTS OF TAXES
When a tax is imposed on a commodity, it produces certain effects on the producer, the
consumer, and the economy.
Suppose the government levies excise duty on tea, it will raise the price of tea, which will reduce
the disposable income of the consumers of tea who will, in turn, reduce its consumption.
If the tea companies are not able to shift the full amount of the excise duty to the consumers (for
fear of reduction in sales), their cost of production rises and the profit-margins are reduced.
This will adversely affect investment and production. If they are not able to shift the incidence
of the tax backward on the suppliers of factors of production, investment will again be adversely
affected.
These are the effects of a tax which may, in the long run, adversely affect production,
employment, income, saving and investment in the economy.
Dalton has distinguished the incidence and effects of a tax in terms of its direct and indirect money
and real burdens. The incidence of a tax is its direct money burden which is equal to the total tax
collections going to the treasury.
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Sometimes, a taxpayer has to incur more expenses in addition to the amount of the tax, such as
payment of fee to a tax-consultant for filling up the tax return, and on conveyance for depositing
the amount of tax in the treasury or for submitting the tax return to the taxation officer. This is the
Indirect Money Burden of the Tax. The effects of a tax refer to its real burden which may be direct
or indirect.
The direct real burden is in the form of sacrifice of economic welfare on the part of the taxpayers
as a result of the imposition of a tax when a person has to pay a tax whereby his income is reduced,
it relates to the direct real burden of the tax. When the imposition of a tax reduces the consumption
of a commodity, it is the indirect real burden of the tax. Mrs. Hicks calls the direct money burden
of the tax as formal incidence and the effects of a tax as effective incidence.
From the above, some points of distinction may be made between the incidence and effects
of a tax.
1. The incidence of a tax relates to the money burden of the tax, while the effects of a tax relate
to its real burden.
2. It is the incidence of a tax that leads to its effects and not the other way.
3. The incidence of a tax can be shifted but the effects of a tax cannot be passed on to some other
person.
TAXABLE CAPACITY
Taxable capacity refers to the extent of tax burden which the people can bear in a country. It is a
level up to which taxes can be imposed without harming the interest of individuals in a
Community.
Factors Determining Taxable Capacity
The taxable capacity of a country depends on the following factors.
1. Size of National Income.
Taxable capacity depends on the size of national income or wealth or natural resources of a country
and the extent to which they are developed. The higher the national income, the higher the taxable
capacity of a country, and vice versa.
2. Distribution of National Income.
In a country where there is inequality of income, taxable capacity is high because the few rich can
be taxed heavily. On the other hand, if there is equality of income, the taxable capacity is relatively
low because the government expenditure to uplift the poor will be less.
3. Stability of Income.
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In developed countries, the incomes of individuals are stable, the taxable capacity is high. But
where incomes are subject to fluctuations and are unstable, as in Underdeveloped countries, the
taxable capacity is low.
4. Size and Growth of Population.
If the size and growth rate of population are high, the per capita income will be low. So the taxable
capacity will also be low, and vice versa.
5. Standard of Living.
If the standard of living of the people is high, it means that people are spending more on comforts
and luxuries. So their capacity to pay taxes is also high, and vice versa.
6. Tax System.
The type of tax system affects the taxable capacity. A progressive tax system has a higher taxable
capacity because it falls on higher income groups, as in the case of direct taxes on incomes. On the
other hand, regressive indirect taxes which fall heavily on low income groups have low taxable
capacity.
7. Sources of Revenue.
Taxable capacity depends on the number of sources of revenue available to the government. The
greater the number of revenue sources that are productive, the higher the taxable capacity, and vice
versa.
8. Public Expenditure.
If public expenditure is meant to increase the welfare of the people, people do not mind paying
taxes. If the government spends money on unnecessary and unproductive projects, people will not
be willing to pay taxes. Thus taxable capacity is high for productive public expenditure which
increase national income, and vice versa.
9. Price Situation.
Taxable capacity is determined by the price situation in the country. If prices are rising, the real
income of the people falls and their taxable capacity declines. The converse is the case when prices
are falling.
10. Organization of the Economy.
If the economy is primarily agricultural, the taxable capacity will be low because the income from
agricultural operations is uncertain. On the other hand, an industrial economy has high taxable
capacity because the industrial sector generates larger income than the agricultural sector.
11. Psychology of the People.
33
Taxable capacity also depends upon the psychology of the people. People are prepared to more
pay taxes honestly and willingly during a war and Natural calamities like floods, earthquakes, etc.
As pointed out by Findlay Shirras, “The psychology of the people has much to do with the extent
of taxable capacity. People are often willing to bear heavier taxation on patriotic or sentimental
grounds. On the other hand, adverse psychology of the people towards the payment of taxes lowers
down the taxable capacity.”
12. Political Conditions.
What should be the level of taxation is a political factor these days. A country which has political
stability, its taxable capacity will be high. If there is political Instability or the government is
unsympathetic and repressive; the taxable capacity will be low.
Taxation of income/ INCOME TAX IN KENYA
34
Income tax is the tax payable on income generated by the tax payer.
ADMINISTRATION
Income tax is administered by the following government ministries in Kenya.

The national treasury ( former ministry of finance)

Kenya Revenue Authority
LEGISTATION THAT GOVERN INCOME TAX

Income Tax Act cap 470 is the act that regulates the income tax in Kenya. The income tax
Act cap 470 lays down the legal framework of tax administration in Kenya and consists of 14
parts, 133 sections and 13 schedules. (Can be found on KRA website)The rules and regulations
in Income Tax Act relates to: ascertainment of taxable income, reliefs acceptable to
individuals and body corporate, assessment or changeability to tax and collections and
recovery of tax

Subsidiary legislation - schedules , income tax rules.

Tax Procedures Act, 2015

Income Tax department/ Administrative instructions

Case law
Purpose of income tax
Generally, income tax in Kenya is used for
 Revenue mobilization
 Income redistribution purposes.
 Income tax is used to achieve equity objectives through rationalization of tax brackets and
rates; in other words, tax brackets could be broadened or the number of brackets increased and
the tax rates could be increased or reduced depending on the objective. The redistribution and
equity purposes are more evident with personal income tax than with the other types of income
tax. Evidently, the rationalization of tax brackets and rates is done so as to reduce tax burden
on those with lower and fixed incomes and make the tax more equitable.
How income tax works
35
First, income tax is charged on the income earned by any person resident in Kenya. A resident is
defined as an individual who has permanent residence in Kenya, and has spent any part of the
working year(s) in the country; or, one without permanent residence in Kenya but who has spent
183 days or more, working in the country during the period of assessment. A foreign employee in
a non-Kenyan firm who is resident in Kenya is subject to tax on all emoluments.
Income tax is a direct tax that is imposed on income derived from Business,Employment, Rent,
Dividends, Interests, Pensions among others.
Methods of collecting Income Tax include:
 Pay As You Earn (PAYE)






Corporate Tax
Withholding Tax
Installment Tax
Turnover Tax
Capital Gains Tax
Value added tax
Basis of charge to tax

Tax is charged on the basis of source and /or residence

Income tax is charged on all incomes of person whether residents on non residents which
accrues in or is derived in Kenya.

For business carried on partly within and partly outside Kenya the whole the profit from that
business is taxable in Kenya..e.g transporters and Kenyan incorporated companies with
branches outside Kenya.
NATURE OF INCOME
Income taxes are assessed on the income received by either an individual or corporation. For
purposes of tax income can be classified into taxable income, exempt income and non taxable
income

Taxable income
36
Sec 3(2) of the Income tax act classifies taxable income by reference to the source from which the
income is derived. The sec states that ‘’subject to this act income of one which tax is chargeable
under this act is the income in respect of ‘’
Some items of income are subject to tax and others are not. The Act has listed the income upon
which tax is charged. The income which is taxed is income in respect of:
a) Gains or profits from business
b) Gains or profits from employment or service rendered
c) Gains or profit from rights granted to other persons for use or occupation of property e.g.
rent and royalties
d) Investment income: Dividend and interest
e) Pension, charge or annuity, and withdrawals from registered pension and provident funds
f) An amount deemed to be income of a person under the Act or rules made under the Act
g) Agricultural, pastoral, horticultural, forestry and other similar activities as specified under
sec15 (7)e
h) Gains accruing in the circumstances prescribed in and computed in accordance to the 8 th
schedule of the Act cap 470
a) Exempt Income / Non taxable income
This income should be technically taxable but the law exempts it from taxation. The exempt
income for individual and body corporate is stated in the First Schedule to the Income Tax Act.
1. Income of goverment, Ministries and exempt NGOs.
2. Income of County Goverments
3. Income of any registered pension scheme, registered trust scheme, registered pension fund,
and registered provident fund
4. Income earned by individuals enrolled in the Ajira Digital Program (ADP)- Begining
January the income earned by an individual registered under ADP shall be exempted from
tax for a period of three years provided the qualifying member pays a Ksh 10,000
subscription upon registration.
5. Income of a registered home ownership savings plan
6. Interest earned on a saving account held with Kenya post office savings bank(POSB)
7. Income earned by National housing development fund
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8. Interest income from all listed bonds ( with three years maturity or more ) used to raise
funds for infrastructure and social services…for example ….all listed bonds..notes or other
similar listed securities used to raise funds for infrastructure, projects and assets defined
under green bond standards. The bonds must have a maturity period of more than three
years
9. Dividend income received by an insurance company from investment in an annuity
fund(fund created where specified amount of profits of the tear are deposited for meeting
future financial obligations)
10. Income of the president of Kenya inform of salaries, duty and entertainment allowances
paid to him from public funds.
b) Non taxable income
This income is neither stipulated under sec 3 (2) as taxable income nor is it enumerated in the 1 st
schedule of cap 470 as exempt income. However the practice and norm is that such incomes are
not a taxable they include:
1. Harambee donations received
2. Dowry received
3. Legacy received through a will from deceased person
4. Inheritance
5. Child supports payments
6. Windfall gains and Honoraria
7. Charity sweepstakes winnings
8. Gifts from friends
This is income of a person that is subject to tax under the taxation Acts. It includes,

employment income,

business income,

income arising from rights granted for use of property among others
TAXABLE PERSONS
Those assessable or chargeable to tax are called ‘persons’. ‘Person’ means both individual (natural
persons) and artificial persons created by law. The artificial persons are incorporated and
38
unincorporated companies such as clubs, trust and estates. Partnership is not considered person as
partnership is not taxed rather individual partners’ are the ones taxed.
The persons liable to tax are the following:

All persons resident in Kenya whether or not they are Kenyan citizens

All persons not resident in Kenya but derive income from any property, trade, profession,
vocation or employment in Kenya.
Concept of residence
The concept of residence is used for tax purposes to determine persons liable to tax and has
absolutely nothing to do with the nationality, citizenship or domicile of the tax payer. Sec 2 of Cap
470 states that the word residents for tax purposes can be applied in relation to individuals or
natural persons and body of persons. (Legal entity or body corporate)
The residential status of a person for the purposes of tax is relevant into two basic ways: It affects
the income which is chargeable to tax since residence and non-residence are taxed differently and
for the purposes of granting personal relief. Residents have some tax advantages over nonresidents which relate to tax reliefs, rates of tax, and expenses allowable against some income.
For the purpose of charging tax and determining residential status physical presence in Kenya is
important. Physical presence means being within the Kenyan airspace, Kenyan territorial water,
and Kenyan boundaries.
a) Residents in relation to individuals
Sec 2 cap 470 states that an individual is considered to be a resident if:

He has permanent home in Kenya and was present in Kenya for any period during year of
income under consideration

Has no permanent home on Kenya but was present in Kenya for a period or periods
amounting in total to 183 days or more during the year of income under consideration; or

Has no permanent home in Kenya but was present in Kenya for any period during the year
of income under consideration and in the two preceding years of income for periods
averaging more than 122 days for the three years.
NOTES
1. Incase of a person with permanent home the individual must be physically present in Kenya
for however a short period during the year of income for him to be considered as a resident.
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2. The expression ‘’permanent home’’ has no technical meaning but an indication as to how
the courts of law would interpret the expression permanent home was given in the case of
commissioner general of income tax verses Naruddin Hassanall Noorani (1961 where the
case was concerned with whether a tax payer had a home in the partners states of East
African community. In interpreting the term home the court considered the following
issues:
-
A home does not necessary mean a house, bungalow or a flat .It could even be a
hotel
-
A home may be owned or rented
-
The individual must have unrestricted access and full control of the home
3. The definition of the term ‘’average of more than 122 days ‘’ was given in the case of
commissioner of income tax verses sir George Arnautoglu where it was construed to mean
the aggregate number of days in the current year of income plus number of days in each of
the 2 preceding years divided by three.
Ilustrations:
Michael and Moses visited Kenya between 2005 and 2007 as follows.
Number of days in a year
Number of days in a year
Year
Michael
Moses
2005
365
364
2006
1
1
2007
3
1
Total days
369
366
Average days for three years
123
122
Question: In the year of income 2007 between Michael and Moses who is a resident
Michael was a resident in 2007 as the average days for the three years is more than 122 days while
Moses was not a resident in 2007 as the average days for the three years at 122 is not more than
122 days.
b) Residents in relation to a body corporate
A body corporate is considered to be a resident in any year of income if

Its incorporated in Kenya under laws of Kenya such as companies act cap 486,Insurance
act cap 487,banking act cap 488,cooperatives societies act cap 490
40

The management and control of the affairs of the company was exercised in Kenya in a
particular year of income under consideration

It has been declared by finance minister to be resident in Kenya for any year of income
through a notice in Kenyan gazette
c) Non-Resident: Means any person (individual or body of persons) not covered by the above
conditions for resident.
YEAR OF INCOME
This refers to a period of 12 calendar months which runs from 1st January to 31st December in each
year. The concept of the year of income is important because it’s the period in reference to which
the income of a person shall be taxed. However sec 21 of the income tax recognizes accounting
dates which do not coincide with the 12 months of the calendar year. (Accounting period or year
is the date which the accounts of a company are prepared-for government it runs from July to June
of the following year)
Rates of tax
After determining the taxable income, also referred to as assessable or chargeable income/loss of a
person, the person is taxed.
a) Loss is carried forward on the basis of specified sources until the person makes a profit to offset the loss. The loss from one specified source can only be off-set against future income from
the same specified source.
b) Income is taxed at the prescribed rates of taxation. There are Corporation rates of tax
applicable to companies (legal persons) and there are individual rates of tax applicable to
individuals (natural persons) graduated rates
Corporation Rates of Tax
The corporation rates of tax apply to legal persons such as companies, trusts, clubs, estates,
Co-operatives, associations etc

Corporate rate of tax from years 2000 to date is 30% for resident corporations.

From year 2000 to date, a non-resident company with a permanent establishment in Kenya is
taxed at 37½%.
41
Tax rates for individuals
An individual is taxed at graduated scale rates such that the higher the income, the higher
the tax as follows:
Tax rates per year
2005 to date
Range of income Range of income Bands of income
Tax rate on band
(start range)
(end range)
First
0
121,968
121,968
10%
Next
121,969
236,880
114,912
15%
Next
236,881
351,792
114,912
20%
Next
351,793
466,704
114,912
25%
Last
Over 466,704
Over 466,704
30%
TAX SET-OFFS
Tax set off means to consider any tax deducted at source to be paid to the income tax department. The
persons, who deduct these taxes while making the payments to some individuals, are required to remit
these amounts to the income tax departments. Such taxes can be shown as deductions from the total
tax payable by the individuals. This procedure is known as set-offs of taxes. The main examples of
set-off taxes are: PAYE, Annuities paid under will or withholding tax, reliefs.
1. Personal Relief
The personal relief is claimed and granted only to resident individuals. The relief reduces tax payable
by an individual.
1) The personal relief reduces tax payable by a resident individual only.
2) Any resident individual is entitled to claim personal relief. The relief does not apply to non-resident
individuals or to companies.
3) The personal relief is currently Sh.13,944 p.a (1,162 pm) granted on the basis of number of months
worked during the calendar year.
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2. Insurance Relief
A resident individual will be entitled to an insurance relief at the rate of 15% of the premiums paid
subject to a maximum of Sh5,000 p.m (Sh. 60,000 p.a) if he proves that;
• He has paid premium for an insurance made by him on his life, or the life of his wife, or his child
and that the insurance secures a capital sum payable in Kenya and in the law full currency of Kenya.
• His employer paid premium on the insurance of the life of the employee which has been charged to
tax in the hands of the employee.
• Both employer and employee have paid premiums on the insurance
N/B
Premiums paid for an educational policy with a monthly period of at least 10 years shall qualify for
this relief.
3. PAYE on employment income
The employment income is taxed at source monthly under the Pay As You Earn (PAYE) tax
deduction system. The tax is referred to as Income tax. It will apply to salaries, wages, directors’
fees, benefits, etc. paid monthly to any employee. Every employer is legally required to operate a
PAYE deduction system. The main features of the PAYE system are:
(i) The employers deduct PAYE tax monthly on all employment income they pay to their
employees;
(ii) A PAYE tax deduction card (form P9) is maintained for each employee, showing monthly
gross pay, benefits, allowed deductions, PAYE deducted , personal relief and net pay;
(iii) The details above must be given to every employee by the employer per month, i.e. the pay
slip or pay advice;
(iv) The PAYE deducted must be paid to the Domestic Taxes Department (banked using credit
slip paying-in-book called P11) by the 9th day of the month following the one in which PAYE
was deducted;
(v) The employer is required to issue a certificate of pay and tax (form P39) at the end of each
calendar year or whenever an employee leaves employment;
(vi) At the end of each calendar year, every employer is required to submit the PAYE end of- theyear documents as follows:
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a) The tax deduction cards (form P9) for all employees;
b) Personal relief claim forms duly signed (forms P1, 2 and 4) for all employees concerned;
c) Certificate showing total monthly PAYE deducted for the year (form P10);
d) List of employees and total PAYE deducted from each for the year of income (form P10A).
4. Presumptive income from some agricultural produce
As stated earlier, the gross sale amounts of maize, wheat, barley, rice, sugar cane, pyrethrum,
tobacco leaf, tea leaf, coffee, raw cashew nuts, pigs, fresh milk, raw cotton, hides and skins, are
presumed to be income and subject to Presumptive Income Tax (PIT). PIT was re-introduced with
effect from 1.1.2000 at 2%.
The PIT deducted for individuals, co-operative societies and partnerships is final tax. Where the
PIT is the final tax, the agricultural income does not require to be returned to the Domestic Taxes
Department. For companies, however, the PIT is treated as income tax paid in advance and is used
to reduce the company's tax payable for the year. This means that companies with agricultural
produce are taxed on net profit or loss and they get credit for the PIT as tax paid in advance.
5. Withholding tax
A resident person is required to withhold tax on various payments, under section 35 of the Income
Tax Act. Withholding tax is applicable on payments to both residents and non-residents. Such
payments include dividends, interest, royalties, management and professional fees and agency,
consultancy and contractual fees.
The withholding tax should be viewed as income tax paid in advance. A person making payments
of incomes subject to withholding tax is legally required to deduct the withholding tax or the tax
at source at appropriate rates before effecting the payment and:
a) Remit the tax so deducted to the Domestic Taxes Department
b) Pay the payee the amount net of tax; and
c) Issue the payee with a certificate of the withholding tax or tax paid at source e.g. interest
certificate or a dividend voucher.
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NOTE: For any given year of income, the payee is assessed on gross income and is given credit
for the tax paid at source except in cases where the withholding tax is the final tax.
Benefits of withholding tax
The importance of deducting withholding tax include;
 it makes tax collection easy
 To ensure that certain income does not escape being taxed. The deduction of the tax is the
responsibility of the person paying.
N/B-There is no deduction of withholding tax in-case of any income exempted from income tax
of Kenya.
Payments
Notes
Dividends
Tax rate for
Tax rates for
non residents
residents
5%
Interest-- Housing bonds
A
10%
15%
10%
-
Other
B
sources
Insurance commissions
15%
15%
C
-
Brokers
5%
20%
-
Others
10%
20%
Royalties
5%
20%
Pensions and retirement D
0%-30%
5%
annuities
45
Management
and E
5%
20%
professional fees, training
fees
Sporting or entertainment
20%
income
Real estate rent
30%
Leasing of equipment
Contractual fees
E
Telecommunication
F
3%
15%
3%
20%
5%
service fee
Taxation of wealth
What Is a Wealth Tax?
A wealth tax is a tax on the assets that an individual currently owns.
Wealth taxes allow policy makers to reach the assets of the wealthiest citizens more effectively,
both increasing government revenue and making the system fairer.
These assets include (but are not limited to) cash, bank deposits, shares, fixed assets, personal cars,
assessed value of real property, pension plans, money funds, owner-occupied housing, and trusts.
An ad valorem tax on real estate and an intangible tax on financial assets are both examples of a
wealth tax.
So take a taxpayer who had $10 million in cash and investments, and property assessed at $40
million as of midnight on Jan. 1. He would have $50 million in taxable wealth, and under a 1%
wealth tax would owe $500,000.
Taxation of Purchases
Income taxes don't apply to purchased property, only to net gains in value. Wealth taxes do apply
to purchased property because the new asset still contributes to the taxpayer's net worth.
46
So, for example, consider a taxpayer who was gifted a $1 million house. She would owe taxes on
that property because her net worth increased by $1 million. If she purchased that house she would
owe no income taxes, because her net worth did not go up. She would, however, owe wealth taxes
because it still contributes to her net worth.
Taxation of Non-Liquid Assets
The income tax does not apply to unrealized gains in property value. It only triggers if you sell an
asset and make money off it. The wealth tax typically does apply to unrealized gains, since the
market value of the asset contributes to the individual's net worth.
For example, consider a taxpayer with stocks worth $10 million. A wealth tax that includes stocks
and mutual funds would apply to the entire current value and this investor would pay taxes on it
every year. An income tax does not. It applies only to the profit a taxpayer makes off her
investment, and wouldn't trigger until she sold her stocks.
Capital Gains Tax
What is Capital Gains Tax (CGT)?
CGT is tax that is levied on transfer of property situated in Kenya, acquired on or before January
2015.
It is declared and paid by the transferor of the property
Buying and selling of property is one of the most thriving businesses in Kenya. Whether dealing
with the sale of shares, land or buildings one can get good returns if transactions are done when
the market is favorable.
After the negotiation on sale of certain property is finalized, then the seller or transferor of the
property needs to bear in mind that they have an obligation to pay Capital gains tax.
Rate of Tax
Capital Gains Tax (CGT) is tax that is levied on transfer of property situated in Kenya whether it
was acquired on or before January 2015.The rate of tax is 5% of the gain and is paid by the seller
or the transferor of the property. It is a final tax and therefore not subjected to further taxation after
payment.
The
rate
of
tax
is
5%
of
the
net
gain.
It is a final tax i.e. the Capital Gain is not subject to further taxation after payment of the 5% rate
of
tax.
Net Gain is Sales Proceeds minus the Acquisition and Incidental cost
CGT is on gains arising from sale of property.
47
Purpose of a Wealth Tax
The stated purpose of a wealth tax is threefold.
1. Create a Policy That Can Reach Wealthy Taxpayers
Wealth tax advocates argue that income taxes are poorly structured to reach the wealthiest citizens.
Unlike working- and middle-class taxpayers, the highest earners typically make most of their
money from investments and property holdings.
As a result, it has historically proven difficult to write an income tax policy that can target the
wealthy as effectively as it targets salaried and hourly workers. Wealth taxes allow policymakers
to reach the assets of the wealthiest citizens more effectively, both increasing government revenue
and making the system fairer.
3. It Reduces Inequality
The wealthiest 1% of Kenyan hold approximately 40% of all the money, land, cars and everything
else of value in the in Kenya. These class would hold more than 70% of the national income. A
wealth tax would reduce that.
By targeting this massive pool of unequal wealth directly, the government could slowly
redistribute it. This would both fund programs that tax advocates support and would reduce
inequality by reducing the holdings of the ultra-wealthy.
Criticisms of the Wealth Tax
It Would Duplicate Taxation
Under these policy citizens would owe taxes on the same money again and again, in the same way,
homeowners pay taxes on their house each year. This is referred to as double taxation, referring to
the fact that a wealthy taxpayer would pay an income tax on their earnings, then a wealth tax for
holding onto that same money.
Critics of a wealth tax argue, among other concerns, that this is simply unfair as a matter of public
policy. Eventually, taxpayers should have a right to their money free and clear of government
interference.
It Could Discourage Work
Wealth tax critics also urge that it would reduce the incentive for wealthy taxpayers to do additional
work.
48
If the government imposes confiscatory tax schemes, critics argue, then people will have less
incentive to earn money that they know will simply get taken away again. This will reduce
productivity and make everyone poorer as a result.
49