Chapter 4: Introduction to Tax
4.1 Concept, Meaning, and Objectives of Tax
Tax is a compulsory financial charge or levy imposed by the government (Federal, Provincial, or Local) on individuals, businesses, and goods/services under prevailing law, without any expectation of a direct, quid-pro-quo personal return or benefit to the taxpayer.
- In the words of Prof. Seligman: “A tax is a compulsory contribution from a person to the government to defray the expenses incurred in the common interest of all, without reference to special benefits conferred.”
- In Nepal, domestic tax administration is governed by the Inland Revenue Department (IRD) under the Ministry of Finance.
Objectives and Importance of Taxation
- Collection of Public Revenue: Primary source of government income to fund administrative expenses, salaries, defense, and public services.
- Infrastructure and Economic Development: Finances roads, bridges, hydropower, schools, hospitals, and drinking water projects.
- Reduction of Economic Inequality: Progressive taxation taxes high-income earners at higher rates and funds social security, scholarships, and subsidies for low-income citizens.
- Protection of Domestic Industries: Imposing higher customs duty on imported luxury/competing goods protects domestic manufacturers.
- Control of Harmful Consumption and Inflation: Heavy excise duties on tobacco, alcohol, and luxury items discourage harmful consumption and curb excess purchasing power.
4.2 Canons / Principles of Good Taxation
Classical economist Adam Smith (in The Wealth of Nations, 1776) propounded four foundational canons of taxation, supplemented by modern economists:
- Canon of Equality / Ability to Pay: Citizens should contribute toward the support of the government in proportion to their respective abilities (higher tax rate for higher income).
- Canon of Certainty: The time of payment, manner of payment, and exact amount to be paid must be clear and certain to the taxpayer and not arbitrary.
- Canon of Convenience: Every tax ought to be levied at the time and in the manner most convenient for the contributor to pay (e.g., TDS deducted at the time of receiving salary, or VAT paid at the time of buying goods).
- Canon of Economy: The administrative cost of collecting a tax should be minimal so that almost the entire sum collected enters the state treasury.
- Modern Canons: Canon of Productivity (generates sufficient revenue), Canon of Elasticity/Flexibility (adjusts with economic growth), Canon of Simplicity (easy to understand), and Canon of Diversity (broad tax base covering direct and indirect sources).
4.3 Classification of Taxes: Direct Tax vs. Indirect Tax
Based on incidence and shifting of the tax burden, taxes are divided into two categories:
1. Direct Tax
A Direct Tax is a tax levied directly on the income, remuneration, profit, or wealth of an individual or legal entity, where the impact and incidence fall on the same person. The taxpayer cannot shift the burden of a direct tax to another person.
- Examples in Nepal:
- Income Tax: Governed by the Income Tax Act, 2058; levied on Employment Income (Remuneration), Business Profit, and Investment Income.
- Remuneration / Social Security Tax: Under the Finance Act, 2083 (Fiscal Year 2083/84), the first Rs. 10,00,000 of an individual’s yearly employment income is taxed at only 1% (the social security tax). Income above that is taxed in progressive slabs of 10% (Rs. 10–15 lakh), 20% (Rs. 15–25 lakh) and 27% (above Rs. 25 lakh), with an extra 2% on income above Rs. 40 lakh, making the top rate 29%. The slabs can change with each year’s Finance Act.
- Property / House and Land Tax: Collected by Local Governments.
- Vehicle Tax and House & Land Registration Fee: Collected at the Provincial/Local level.
- Casual Gain Tax: Levied on lottery, prize, or windfall gains (25%).
2. Indirect Tax
An Indirect Tax is a tax levied on the production, import, export, or consumption of goods and services, where the initial tax is paid by the importer, manufacturer, or seller (impact), but the burden is shifted forward to the final consumer (incidence) by adding the tax to the price of the product.
- Examples in Nepal:
- Value Added Tax (VAT): Governed by the Value Added Tax Act, 2052; a multi-stage consumption tax levied on value added at each stage of production and distribution at a single standard rate of 13% in Nepal (with 0% on exports and exemptions on basic agricultural/medical/educational items).
- Customs Duty: Levied on goods imported into or exported out of Nepal at border customs offices.
- Excise Duty: Levied on the manufacture or import of specific goods (such as alcohol, cigarettes, cement, vehicles, and beverages).
Comparison Between Direct Tax and Indirect Tax
| Basis of Comparison | Direct Tax | Indirect Tax |
|---|---|---|
| 1. Meaning & Basis | Levied directly on the income, profit, or property of a person or institution. | Levied on the production, import, export, or sale of goods and services. |
| 2. Shifting of Burden | Burden cannot be shifted; the person on whom it is imposed bears the final payment. | Burden can be shifted; paid initially by the producer/seller and recovered from the final consumer in the price. |
| 3. Nature of Equity | Progressive in nature; reduces income inequality by taxing the rich at higher rates. | Regressive in nature; both rich and poor pay the same tax rate (e.g., 13% VAT) on the same commodity. |
| 4. Civic Consciousness | Creates high civic consciousness because taxpayers directly feel the payment and demand government accountability. | Creates less tax resistance/consciousness because the tax is hidden inside the retail price of goods. |
| 5. Examples | Income Tax, Remuneration Tax, Property Tax, Vehicle Tax. | Value Added Tax (VAT), Customs Duty, Excise Duty. |
4.4 PAN (Permanent Account Number) and Tax Compliance in Nepal
- PAN: A unique 9-digit computer-generated identification number issued by the Inland Revenue Department (IRD) to every taxpayer (Individual PAN for employees/citizens and Business PAN for firms/companies). Under Nepal’s policy of “One Person, One PAN”, salary payments and business transactions require mandatory PAN registration.
- VAT Registration Threshold: Businesses dealing in taxable goods exceeding Rs. 50 Lakhs annual turnover (or Rs. 30 Lakhs for services/mixed transactions) must register for VAT and issue VAT invoices showing the 13% tax separately.
4.5 CDC Textbook Exercises & SEE Practice Questions
Group A: Very Short Answer Questions (1 Mark Each)
- What is indirect tax?
- What is the current rate of Value Added Tax (VAT) in Nepal?
- Write the full form of PAN and VAT.
- Who propounded the four classical canons of taxation?
Group B: Short Answer Questions (5 Marks Each)
- What is tax? Explain any four major objectives of levying tax by the government.
- Differentiate between Direct Tax and Indirect Tax in five points with suitable examples.
- What is Value Added Tax (VAT)? Explain the features and importance of VAT in Nepal’s revenue system.
Worked answers to these exercises are in Chapter 4 Solutions.