Progressive Tax Intentions Bring Regressive Outcomes for Low Income Earners

Jun 15 , 2024
By Brook K. Abebe

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Ethiopia's progressive tax system, designed to distribute the tax burden more equitably across different income levels, ensures that higher-income people contribute a larger share of the country's revenue. The system is intended to fund public services and infrastructure, thereby supporting the country's development.

However, its implementation has raised concerns, particularly over the taxation of low-income individuals. Despite the equitable intentions, the progressive tax system may inadvertently place undue pressure on vulnerable populations struggling to afford necessities.

The tax system begins taxing employment incomes from the lower end of the earning spectrum. Individuals earning a monthly income of over 601 Br (approximately 11.50 dollars at the current exchange rate) are subject to taxation. The amount is barely sufficient to cover essential monthly needs and falls well below the estimated poverty line for 2024. Taxing individuals at this level can be particularly burdensome for low-income earners, who are already struggling to meet their basic needs. The law exempts individuals earning less than 600 Br from income tax, ostensibly to protect the poorest segment of the population and ensure that their basic income remains unaffected by taxes.

However, the threshold raises questions about whether employees currently earn 600 Br a month and whether this income level, while non-taxable, truly benefits people experiencing poverty. The threshold requires careful review. Considering the private and public sectors, the average minimum wage must be reviewed. Continuously evaluating and adjusting tax policies to meet changing economic circumstances and the population's needs is essential.

Tax revenue has supported economic growth over the past 15 years, averaging around 10.2pc a year in real terms. However, setting the tax threshold too low can have detrimental effects, particularly for those hovering above the poverty line. The recent increase in the VAT threshold from 500,000 Br to one million Birr indicated public outcry and unrest, suggesting that the previous threshold was too burdensome for small businesses.

However, the tax system must balance the economic realities of the population. If the tax threshold is set too low, it risks pushing those just above the poverty line back into poverty, which is counterproductive to development efforts. Reports indicate that wealthier individuals and entities often avoid tax, leveraging their influence and connections with government officials to reduce tax liabilities. This results in a loss of crucial revenue for the state and creates an environment where progress is stunted due to the unequal distribution of the tax burden.

Taxes are a primary source of government revenue, and without them, it would be challenging to maintain public services or invest in public infrastructure. Ethiopia operates under a federal tax structure where the federal government and regional states share the power to levy and collect taxes. Federal income taxes, outlined in a proclamation issued in 2016 and a Council of Ministers Regulation passed in 2017, represent a milestone in the country's efforts to establish an equitable, modern, and efficient tax system aligned with its economic development goals.

These laws detail the obligations of taxpayers and the government, delineating the income taxation process through five distinct schedules, including the employment income tax. The tax burden on employees, especially those with low incomes, can impact their living standards, directly affecting their right to a decent standard of living and impeding their ability to access basic needs such as food, shelter, and healthcare.

Transparency International's ranking of Ethiopia at 98th in 2023 revealed the pervasive corruption within the public sector, manifesting in various forms, including quid pro quo arrangements and other illicit practices that enable tax evasion. Such activities divert funds away from developmental programs meant to benefit the public, thereby infringing upon the rights of those who faithfully contribute their taxes.

The tax system in Ethiopia is more favourable than those in countries with regressive taxation, but it still faces limitations in adequately protecting its lower-income earners. Progressive taxation aims to levy taxes based on taxpayers' ability to pay; higher earners pay a larger percentage of their income than lower earners. This contrasts with regressive taxation, where the tax rate diminishes as the amount subject to taxation increases, disproportionately affecting those with lower incomes.

Nordic countries like Sweden, Norway, and Denmark have long been recognised for their progressive taxation systems, which levy higher rates on the wealthy and reinvest the revenues into expansive social welfare programs. These programs encompass universal healthcare, free higher education, and robust social security nets, collectively facilitating a high standard of living and economic equality. The additional revenue from wealthier taxpayers supports those at the lower end of the income scale, ensuring universal access to essential services and opportunities for advancement.

Ethiopia might find inspiration in the Nordic model for reforming its tax system to better serve its citizens.

A fundamental principle of taxation, horizontal equity, asserts that individuals with equivalent economic capacity should incur equal tax liabilities. This principle ensures fairness by requiring that two individuals with identical incomes are taxed at the same rate, resulting in the same amount of taxes paid. However, the practical application of progressive taxation systems, including Ethiopia's, often strays from this ideal. Tax exemptions, deductions, and benefits can disproportionately favour those with higher incomes, undermining the goal of equity.

For instance, the annual business income tax is lower than the employment income tax for the same income level. Business income may benefit from different tax treatments, such as the right to deduct certain expenses or apply different tax rates. Consequently, two individuals with the same income might pay different tax amounts, contradicting the principle of horizontal equity. The disparity calls for evaluating tax policies to ensure they adhere to principles of equity and fairness, promoting a tax system that is equitable and conducive to economic growth.

By adjusting tax policies to reduce the burden on people with low incomes — such as increasing the tax-exempt income threshold and offering targeted tax relief for vulnerable sectors like agriculture — the government could safeguard the rights and livelihoods of its lower-income population. Economic policymakers and tax authorities must consider these factors, especially given the inflationary pressures further straining the finances of the poor. They can create a more equitable tax system that promotes inclusive growth and protects the rights of all citizens, particularly the disadvantaged and marginalised.

The informal sector’s substantial size and tendency to operate outside the formal tax system impact the government's ability to collect employment income tax. This has led to a reduced formal tax base and disparate treatment of taxpayers. Evidence shows that the informal sector is a major factor in the tax revenue to GDP ratio, which fell from 16.2pc in 2002 to 6.9pc in 2020. This is notably lower than the average for sub-Saharan African countries, indicating a limitation in mobilising revenue from this sector.

The informal sector’s tax evasion unfairly burdens formal employees who comply with tax laws. There is a pressing need for tax policy reforms that effectively integrate the informal sector into the formal tax system. Such reforms would ensure a fairer distribution of the tax burden and enhance the government’s capacity to fund essential services and development projects.

Addressing the informal sector’s tax compliance is crucial for creating a more equitable tax system that supports sustainable economic growth. By implementing targeted policy measures, authorities can work toward developing a tax framework that is fair, efficient, and conducive to the economic well-being of all citizens. The enforcement of tax laws must be free from discrimination, as any form of discriminatory practice in tax collection or imposition would raise human rights concerns.

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PUBLISHED ON Jun 15,2024 [ VOL 25 , NO 1259]

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