Tax is simply a compulsory contrition towards the state by a person (natural or artificial) imposed by the government. It may called fine, fee, duty, custom, toll, excise, tariff, tribute, or any other name.
Although governmental authorities may levy taxes for different reasons but there are two basic objectives for levying taxes:
- fair distribution of wealth in the economy; this is done by taking money from people and applying it to areas or sectors that need help to progress at reasonable rate so the society is not significantly divided in classes.
- to enable government in providing infrastructure and services that are needed by masses rich or poor alike e.g. roads, hospitals, schools, trade market etc.
In simple words, taxation allows government to regulate the flow of money by taking it away from individual majority of whom are thinking of their own individual benefit and applying to common good so that at least basic necessities are available to every member of the society. By taking away the money from the pockets of individuals who are going to consume it, government channel to something progressive that improves the living standard of society as a whole.
1 Types of taxes
Based on the possibility that tax can be shifted, taxes can be of two types:
- Direct tax is a tax that is payable by the same person on whom it is imposed. In simple words the burden of tax cannot be shifted to another person. Examples are income tax, corporate tax, capital gain tax etc
- Indirect tax is a tax in which tax is imposed on one person but ultimately paid by another person. In simple words the burden of tax can be shifted to another person. Examples are sales tax, duties etc.
Based on the calculation or rate of tax, tax can be of four major types:
- progressive: in this system increasing tax rate is applied i.e. the rate of tax increases as the underlying amount (income or revenue) increases. For example with increase in income, the rate of tax will increase as well and as income decreases rate of tax reduces as well.
The concept behind progressive taxation is that people earning more should be contributing larger proportion of their wealth to the society whereas the ones earning lesser should contribute in smaller proportion.
- regressive: in this tax mechanism decreasing tax rate is applied i.e. the rate of tax decreases as the underlying amount increases i.e. more the income lower the tax rate. Or smaller the income higher the tax rate.
The concept behind progressive taxation is that people with low income or below average income level are not good spenders therefore, taking larger sum of money out of their pocket, government can better spend the money on their behalf for the benefit of members of society with similar income.
- proportional: in this tax system a constant or fixed tax rate is applied i.e. government will announce a percentage or rate of tax and it is applied irrespective of the underlying amount. For example 15% of income or 5% of turnover.
The concept behind this mechanism is that every member of the society should contribute on equitable basis. Whatever they earn they should contribute out of the total accordingly. Automatically the person earning higher income will pay higher amount of tax and person earning lower will pay lower amount of tax.
Remember in all three tax systems i.e. progressive, regressive and proportional we are mentioning percentage or rate of tax that is applied in a different pattern. Progressive has increasing pattern, regressive has decreasing and propertional has constant or fixed pattern.
- Flat: in this system instead of a percentage a fixed amount is charged irrespective of underlying amount. Remember under proportional system tax is determined on the basis of fixed rate whereas in flat system tax is a simple figure. For example licence renewal fee of $20 is a fixed amount. Withholding tax of $100 is an example of flat tax. Whereas 10% of revenue is an example of proportional tax.
2 Importance of taxes for accountants
Understanding the nature of tax i.e. direct or indirect and the rules of calculation are important for accountants as they may affect reporting of entity’s assets and liabilities. Wrong classification of tax may lead to wrong invoices charged to customers, incorrect sales and cost of sales figures and most importantly tax liability. If tax calculations are significantly wrong, entity may have to face criminal charges if entity is paying lesser amount of tax intentionally or unintentionally on the basis of tax evasion.
Therefore, accountants or any other person responsible for tax calculation needs to understand the basics and the applicable tax laws, rules and regulations.