# finance

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# Problem of Classical Taxation in Ethiopia

Tax is the major source of government revenue, (in Ethiopia covers more than 75% of the federal government budget) needed to finance both economic and social infrastructures and services. [1] To achieve the revenue objective, the Ethiopian government has been introduced different types of taxes. Taxable income under the proclamation shall include, but not limited to: [2] â€¦ (b) Income tax from business bodies taxable at the rate of 30%, and taxable business income of other taxpayers ranges from 0-35% depending on the income brackets; â€¦ (h) dividends distributed by a resident company 10%; etc. Having this information it is important to assess the impact of Ethiopian tax policy on corporate business and unincorporated business. Assume corporate business X plc and individual owned business Y makes yearly profit of Birr 100,000 during 2008 budget year each in their independent business.

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The tax liability to be paid by X plc and Mr. Y will be as follows. Company X at corporate business level will expect to pay Birr 30,000 (100,000*30%) and if we assume the rest income will distributed as dividends to shareholder, again tax to be paid at shareholder level will be Birr 7000 (70,000*10%), here the final total tax amount is Birr 37,000 and hence, the effective tax rate in this particular example is 37%.

On the hand tax to be paid by Mr. Y business will be calculate in the following table.

0-1800

Exempt threshold

1801-7800

10

600.00

7801-16800

15

1,350.00

16801-28200

20

2,280.00

28201-42600

25

3,600.00

42601-60000

30

5,220.00

Over 60,000

35

14,000.00

## 27,050.00

Source: own example and computation based on the income tax proclamation No. 286/2002 Article 19, Schedule "C"

As clearly indicated in the above table, the tax revenue to be collected from Mr. Y is Birr 27,050.00. Even though in most cases it may not be true, under the assumption of all corporate profits after corporate tax will distributed to its shareholders as dividend, operating at individual business have more tax advantageous than operating under corporate companies. Corporate businesses in Ethiopia are not only faced a double taxation burden (30% at corporate level and 10 % at shareholder level), but also the tax law has imposed high effective tax rate compared to the individually owned businesses. This problem is supported the concept of split rate systems arise in the classical system of corporate taxation plus a double taxation constitutes a bias against equity finance. This excessive tax rate, leads to adverse economic effects as it makes taxpayers to change their behavior to avoid or lessen tax liabilities, hence, it also leads to discourage saving, investment and work.

The next important issue is to assess the trend of the corporate tax and the dividend tax by comparing the tax revenue collected from the corporate tax payers' count with dividend tax payers' count in Ethiopia.

2006

6965

100

1.4

1,735,024,752.06

39,218,611.16

2.3

2007

8673

230

2.6

2,166,100,403.73

87,273,128.63

4.0

2008

10160

372

3.7

3,319,920,333.16

95,719,088.30

2.9

## 3.1

Source: Own Computation based on data sourced from ERCA SIGTAS

The above table illustrates the tax payer counts and the amount of tax collected sourced from corporate businesses at corporate level and shareholder levels. The number of corporate tax payer count and divided tax payer count increased from 2006-2008 budget years by 84.8% and by more than threefold respectively. On the other hand the shares of dividend tax payers' count as the corporate tax payers renege between 1.4 to 3.7 percent. Similarly the average tax revenue collected from corporate profit during 2006-2008 was Birr 2,407,015,000 compared to Birr 74,070,000 tax revenue collected from dividend. The revenue collected from dividend tax is 3.1 percent of the revenue collected from corporate profit taxes. This indicates that most of the corporate profits did not distribute to shareholders, rather may reinvest or save at the corporate levels. Based on the above illustration the Ethiopian tax policy discourages distributed of dividends and hence to some extent it also minimizes the double taxation problems.

But it faces equity related problem between the low income and high income earners. The problem may be sourced from the classical tax policy regime, applied not only to achieve the objective of collecting maximum revenue but also used as a policy instruments to manage investment, equity and economic efficiency. To get a better understanding on the classical tax policy regime, it is important to assess the three models of corporate taxation, namely; full integration, classical system and the partial integration system. [3]

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Under a 'full integration' model the corporate form is ignored for the purposes of identifying the relevant tax entity(s) and the shareholders are attributed with their own shares of the corporate profits, losses, tax credits etc in the year that they arise. Therefore under this tax model with respect to S (small) corporations, corporate profits are allocated to the shareholders for the relevant income year, and then being subject to income tax at each shareholder's respective marginal income tax rate. It seems the most appropriate model as a result of allowing income tax to be imposed on those who possess the legal power to control corporate profits. However there are also problems such as; produce of non tax benefits in terms of stronger corporate governance and also managerial benefits arising from improved information, discourages to be a big corporation, loss of government revenue due to the corporate profits distributed to nonresident shareholders, etc.

The second model is the 'classical system of corporate taxation.' Under this model the company is recognized as a separate taxable entity. The weather corporate profits should be subject to tax or not. Briefly, one view income tax distorts investment decisions because it encourages people to spend rather than save and hence better to minimize corporate taxes. The opposing view sets, if corporate profits are not taxed then there is a problem of fairness. The wealthy people are most able to take advantage of this planning, as they have the financial capacity to save whereas lower income groups would not be able to retain investment income within controlled companies. [4]

However, the OECD has reviewed the various literatures on this issue and concludes that there is no complete answer of this question either way. Rather, the solution to the question will depend upon the critical objective and also the general taxation context with respect to which corporate taxation is being considered to whom tax payer? And to what degree does the country rely upon foreign direct investment (FDI)? To answer this question there are many options for how corporate distributions are treated under this classical system of corporate taxation.

Deductible dividends paid to shareholders in the relevant income year insure that corporate profits would not be subject to double taxation. This would achieve neutrality between debt and equity funding; neutrality between resident and non-resident shareholders; but might be come up with disadvantageous to the country in which the company is inhabitant, by facing a loss of revenue to be collected from nonresident shareholders and revenue to be collected from tax exempt shareholders who would have to be allowed a credit for tax paid at the corporate level, if we were to accept such arrangements.

Another approach to handle corporate profits may be to impose taxes only at corporate level and exempt dividends paid to shareholders. This would also solve the double taxation problems but may have equity related short comings. In this scenario, the low income groups may loss more and the high income earners may benefit more, when the corporate tax rate exceeds the respective shareholder's marginal tax rate. [5]

A third option is 'partial integration model or dividend imputation systems of taxation. Corporate tax can be imputed against personal tax obligations on dividend income, in the dividend imputation tax system. Practically, it removes the double taxation of dividends that exists under a classical tax system. The shareholder obtains the cash dividend and an imputation tax credit used to offset personal income tax obligations, while a dividend is paid out of corporate profits that have been taxed at the existing corporate tax rates. For instance, countries such as Australia, New Zealand, Mexico, Finland, and Norway operate full imputation tax systems in which all of the corporate tax paid can be offset against personal tax obligations. UK, France, Italy, Canada, Ireland operate partial imputation tax systems in which part of the corporate tax paid can be offset against personal tax obligations. [6] Partial integration entails taxation at the corporate level with respect to gross corporate profits and also taxation at the shareholder level. However, resident shareholders receiving dividends from the corporate level also receive a credit for that corporate tax paid. If the shareholder is a non-resident, no credit is allowed but nor is any withholding tax imposed with respect to the dividend paid to the shareholder.

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Other literatures are suggested also dividend imputation provide increase incentive for resident investors to participate in ownership of resident companies, if imputation credit is only applicable to dividends paid out of profits which have borne resident tax, improve the climate for shifting the bias away from corporate debt onto equity by effectively reducing the double taxation of dividends. This also provides more incentives for investors to regard dividend as an important investment consideration. [7] However there are also problems such as, the washing out of tax preferences received by the company, the double taxation of retained earnings in certain circumstances, and dividend streaming. Dividend imputation taxation system overall result suggest a need for further development of theory to explain the cross-sectional differences in dividend payouts across firms.

Therefore as an adviser in the area of corporate tax policy issues to the Ethiopian government policy makers, the classical system of corporate taxation has problems relating to distortion of tax payers decisions towards investment and equity related issues and the dividend imputation tax system has also the stated problems. With all this limitation, it is relatively feasible to introduce a dividend imputation system to solve problems relating to tax induced miss-allocation of resources and equity related problems.

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