9002yraurbeF IN PRACTICE investment climate 1.on BUSINESS TAXATION 48313 Small Business Taxation Reform to encourage formality and firm growth Reforming a tax system for small businesses is complicated. No single Jan Loeprick best practice can solve all the issues that arise in trying to implement Jan Loeprick (jloeprick@ a tax system that is simple, administer-able, and equitable. This note worldbank.org) advises client presents a menu of considerations and "good practice" options. It is governments as a member of the World Bank Group's Invest- the first in a series of five notes addressing issues that governments of ment Climate Department developing countries face in reforming their tax systems. (CIC) business taxation prod- uct team. His work focuses on tax regime diagnostics and the When small business taxation is considered with taxpayer capacity and skills (in accounting, implementation of reforms that solely from a revenue perspective, its potential for instance), and very few interactions with will reduce barriers to compli- for developing countries is often overlooked. government officials to limit opportunities for ance, investment, and growth The benefit of a wider tax base in the medium corruption. Compliance should be linked to to long term may not seem to offset the the benefits of being formal. The administrative in developing countries. comparatively high cost of administering small costs of dealing with small taxpayers must be contributors. However, small business taxation kept to a minimum for resource- and capacity- This note and others in the se- should be seen as an entry point to formality. A constrained tax authorities. Combining and ries of IN PRACTICE notes on good tax regime for small firms is a key policy reconciling these objectives into a detailed and business taxation reform were tool to pave their way out of the "informality actionable strategy is difficult; tax policy-makers developed as part of a joint trap" of low growth, limited access to markets, always face trade-offs between simplicity, and exclusion from formal financial services. A fairness, efficiency, and administrative program between DFID (the formal small-business sector advances reciprocal feasibility. United Kingdom's Department relationships between the state and a majority for International Development) of its citizens--those involved in small-scale and CIC. The program focuses economic activities. No single "best" solution on operational issues in tax re- form, particularly those related There are several options, but no one absolute General design principles design for a clear, simple, and transparent to micro-enterprises and small system that reduces compliance costs for small businesses. The CIC business Innovative and successful taxation strategies to firms and administrative costs for the tax taxation product line helps gov- encourage formalization are in short supply, authorities.Countryspecificsandlegaltradition ernments implement effective even though the parameters for a good regime require individual solutions, and successful tax tax systems to spur investment seem relatively straightforward. Small business regimes are sometimes less dependent on the and economic growth. taxation should be designed with minimal design of the right instruments than on the compliance costs, requirements commensurate quality of tax administration. The design of a small business tax regime needs to be guided by the Presumptive systems are usually based on turnover, quality of institutions in place. assuming that most firms monitor their cash receipts, or on specific indicators (for instance, floor space, number of employees, or electricity Simplify the general system or create a special consumption) or a combination of the two. regime? Another option, to be implemented in Egypt, is to approximate the small business' taxable income as At the outset there are basically two options (see its cash flow, which is defined as the difference Figure 1). First, reform measures can offer a between cash receipts and expenses. The cash flow simplified procedure based on the general system has more record-keeping requirements provisions of the existing tax system. The same than turnover- or indicator-based regimes, but is instruments apply, but they are streamlined for better suited in graduating firms to the general smaller firms. This approach is relatively common system. Turnover can be taxed directly at a low in more developed economies. In countries with rate, or used to determine assessable income based high levels of informality, a pronounced departure on a factor approximating profitability. from the general system may be justified to encourage formalization of small and medium- The main idea behind all presumptive schemes is sized enterprises (SMEs). In these cases, a single to reduce the time and costs of compliance and tax presumptive tax is introduced to replace all other administration. These regimes trade fairness for fiscal levies. simplicity and may introduce distortions into the system. Indicators are usually crude proxies for business profitability. Turnover-based systems are burdensome for firms with low profit margins and generous for those with high margins. Special The Costs of Informality simplified regimes for small firms are in demand and frequently recommended to promote Informality comes at a price to both firms and governments. For many compliance. Many developing countries already use some sort of presumptive tax systems for small reasons, informal firms are less apt to grow and invest. Governments suffer contributors. Results are mixed; again, the main both from the lack of formal entrepreneurship that can drive economic challenge in most countries is to make presumptive growth and the loss of tax revenues to pay for public goods and services. taxation work on an administrative level.1 Companies in the informal sector need to operate under the radar of the tax administration. Therefore, they often prefer to restrict firm Administering small business taxation size and growth to avoid attracting attention. The lack of access to formal financial services limits firm investments. In many developing countries, the administration Informal firms are usually excluded from public procurement of small firms is an afterthought for tax contracts, which often constitute a considerable part of the economic administrations and in technical assistance activities in developing countries. programs. This is due to the low benefit-cost ratio of administering small contributors from a revenue Operating informally is not free of charge. Informal firms may need perspective. to frequently change location or activities, pay bribes, or split their businesses into several smaller units at various locations. Whether or not a special tax is introduced, a special Informal firms tend to have lower productivity because they operate administrative approach for small firms is in an uncertain state and do not invest in their businesses and indispensable. Low compliance costs are essential employees. to encourage formalization, because the time and financial burden of complying with tax reporting is relatively higher for small firms. For example, a Source: FIAS (2006). FIAS survey of tax practitioners in South Africa shows that compliance costs decrease dramatically as firm size grows. Instruments to achieve scale- based efficiencies include the tools of modern tax IN PRACTICE BUSINESS TAxATIoN 2 administration: self assessment by firms, risk-based For example, small operators in Sierra Leone auditing by the administration, support services, indicated in a FIAS survey that licensing costs and and technological solutions. However, introducing requirements are a key driver of continued these requires careful preparation; self-assessment, informality. for example, requires records that many small firms might not be able to provide without support Coordination between government agencies is services. Also, tax administrations usually have to usually poor, with inconsistent local and central develop a general trust in the small taxpayer, government policies and multiple non-transparent conducting only few risk-based audits. taxes, fees, and non-regulatory "licenses" at the local level. This dynamic provides ample opportunities for corruption and increases both Local administration firms' compliance costs and the administrative costs of local authorities. Creating a successful Local government often plays a critical role in the small business administration is thus closely linked tax administration of small operators. Municipal to the decentralization agenda. levies may inhibit the creation of formal enterprises. Figure 1: Designing a System for Taxing Small Business 1. Simplified 2. Special regimes application of general regime Simpli cation of tax forms, Resumptive tax to replace income Single (presumptive) tax to replace ling and payment process, tax (+VAT) all other taxes alignment of payments turnover tax turnover tax Reduced direct tax rates indicator based indicator based Value added tax (VAT) simpli cation for SMEs 1.Turnover 2. Indicator- 3. Combined 4.Net cash- system based turnover/ flow system indicator- scheme based tax Uniform tax rate Indicators of A principally Records for gross for all SMEs rm size and turnover-based income and Progressive output ( oor system with expenses turnover-based space, number of added indicators tax employees) to counter tax Di erent tax on evasion turnover for di erent sectors (based on average pro t) As shown at the top of the gure, governments should rst consider two basic options when designing tax reform for small business: a simpli ed application of the general tax regime or a special regime. In developing a special regime with a presumptive tax, how much rms are taxed can be based on one of four measures, as shown at the bottom of the gure. IN PRACTICE BUSINESS TAxATIoN 3 Fiscal decentralization reduces the distance However, the role of local administrations should between firms and their tax administration in be cautiously assessed. Political capture by non- order to improve accountability, visible returns, accountable local elites can be worse than a and services, and ultimately, to increase the corrupt, but remote, central authority. Moreover, potential for voluntary compliance. Many fully independent taxing power for subnational countries around the world give significant fiscal governments may conflict with tax harmonization autonomy to local authorities. A full devolution of and coordination objectives and reinforce the policy and administration of small business tendency to squeeze revenue from small operators. taxation to the local level (including setting rates, determining the tax base, and collecting revenues) A centralized small business tax unit is consistent with the decentralization agenda of increased local autonomy. A specialized tax unit realizes economies of scale in dealing with small businesses, rather than relying on resource- and capacity-constrained local authorities. Such a unit, similar to separate large taxpayers' administrations, is responsible for guiding policy decisions on small taxpayers' Basic Parameters for Successful compliance issues, and for improving services and Small Business Taxation outreach to small businesses. Government policymakers should consider the particular challenges of The long-term benefit of increasing compliance could justify the significant external funding small firms and those caught in the "informality trap" when designing a required to cover the costs of rolling out a cluster taxation regime that will encourage formality and firm growth. of centrally administered, small taxpayer offices. In large countries, where central tax administrations In countries with high levels of informality and low administrative tend to focus activities on the core areas of capacity, a single presumptive tax that replaces all other fiscal levies economic activity, local government structures may be justified to encourage formalization. This sort of approach remain key players for the collection of small taxpayers' contributions. The main challenge would be a departure from the general system for micro and small under a new tax regime is to reduce administrator businesses. discretion and harassment of taxpayers at all levels Formalization may not always be appropriate, so thresholds need of government. to be set in order to disaggregate micro-, small-, and medium-sized enterprises. This will distinguish subsistence activities from small Private intermediaries and new technology businesses with a lot to gain from becoming formal. A complementary option to centrally or locally While technical assistance on tax is typically focused on the central run small business taxation is to outsource the government, taxation of small business needs to build on local administration of small firms to the private sector. institutions and address problems of local regulations. While controversial, private collection is not a new A cost-benefit analysis of small business taxation needs to include the concept2 and can help governments reduce state-building impact of tax compliance. The focus of small business administrative costs and achieve more efficient tax taxation should be to encourage voluntary compliance; coercion administration. However, the state's long-term interests to expand the tax base and encourage alone is impractical and counters the idea of a social contract. growth tend to conflict with private collectors' A simple and streamlined taxation regime is necessary, but not interests in making (short-term) profits. sufficient to encourage enterprise formalization and growth. Tax Governments also need to ensure that taxpayer reforms should be accompanied by the provision of information and abuses are avoided. Thus, while privatization basic business services. reduces the direct costs of administering taxpayers, it requires substantial and costly monitoring efforts by governments to ensure justice and equity. As a result, privatization is recommended only for a few IN PRACTICE BUSINESS TAxATIoN 4 functions that can be easily screened and require markets and financial services and in realizing little discretion of the private administrator.3 security of tenure and investments. Thresholds should be set to distinguish between three levels: Technology may open additional options for subsistence micro-activities, small firms, and public-private cooperation in administering small medium-sized operations. These thresholds will firms. E-filing of tax returns to reduce administrative inevitably create incentives and result in strategic and compliance costs is widespread and offers good behavior among firms, so any special presumptive opportunities for capacity-constrained governments tax regime needs to include safeguards against to cooperate with the private sector. Although the abuses. scope for full e-government solutions may be limited in countries with heavy infrastructure constraints, there may still be widely applicable solutions based on technology already in use. For example, tax payments via mobile phone-based banking systems could allow businesses to pay taxes and fees directly, thus reducing interactions with Administrative Reforms Focused on tax collectors and ensuring that payments arrive at Small Business their destinations. The following administrative reforms contribute to a streamlined Applying lessons learned to system for small business taxation that makes it easier for small firms design and implementation and entrepreneurs to comply. challenges Specialized taxpayer offices and segmented offices can ensure specialized taxpayer services, effective feedback and complaint Defining and disaggregating smaller firms mechanisms, and a credible and affordable appeals process. Streamlined procedures: overall and for small firms. Procedures, forms, There is no universal definition for small and medium-sized enterprises. Small and medium-sized and payment modalities must be tailored to small firm capabilities. firms in an OECD4 environment are considered Bookkeeping requirements need to be simplified. large in most developing countries. For purposes of Self assessment and risk-based verifications. Small businesses should taxation, it is misleading to consider smaller firms be able to declare turnover, determine their tax liability, and pay in as one homogenous block; different sized businesses a single step. Audits need to be risk based, selective, and limited to may require different policy approaches. turnover verifications. Encouraging voluntary compliance is usually the goal for micro and small businesses. Curbing tax Improved outreach to small taxpayers and compliance support services evasion by larger medium-sized firms requires (possibly through private intermediaries). Small operators may not advanced control mechanisms. A variety of criteria have access to information on how to register or operate a firm including volume of sales, size of workforce or formally. Education campaigns and support services at the local level capital, form of ownership, production techniques, are required to facilitate compliance for small taxpayers. capacity, size of premises, and energy consumption Streamlined local regulations and coordination of central and local tax can be applied to disaggregate firms. Arguably, the simplest and most common way to segment efforts ensure that the local tax burden does not become a deterrent to taxpayers is by turnover. formalization. Information technology solutions, including e-government and Setting adequate thresholds payments through mobile phone banking channels, can streamline the process and simplify access for taxpayers to pay. To tap into the growth potential of informal businesses, it is important to target those likely to benefit significantly from becoming formal. These entrepreneurs will see value in accessing new IN PRACTICE BUSINESS TAxATIoN 5 Determining profit margins and setting Integrating small businesses into the reform appropriate rates process through regular consultative dialogue Constructing appropriate indicators and setting an Bringing small operators into the formal economy appropriate tax rate is challenging. It requires requires their trust in the tax authority. Perceptions extensive analysis of profit margins and will usually can be changed through improved outreach, be disputed by some in the business community. services, and public-private dialogue to engage the Small businesses are not necessarily small earners; private sector in the reform process from the outset. rates need to be high enough to encourage firms at the upper end of the threshold to join the general system and low enough to encourage informal Conclusion and outlook entrepreneurs to comply. This process requires extensive survey-based analysis of small firms' profit Moving informal businesses into the formal margins to determine presumptive tax rates. economy through taxation requires a simple process that can be easily mastered even by small operators. Despite the challenges highlighted above, the Building linkages between taxation, licensing, simplest approach--a presumptive tax based on and business registration fees turnover--may well be the most appropriate solution for many developing countries with large The central goal of small business taxation reform is informal sectors. A single tax is particularly useful to further participation in the formal economy and in countries with numerous small "nuisance" taxes, build a culture of compliance. Yet many countries and if well-administered, is likely to have a strong have important non-tax barriers to formalization. signaling effect encouraging informal entrepreneurs Minimizing compliance cost goes beyond taxation to become compliant. Micro-enterprises should be issues and should include other start-up and required to pay a one-time fee per year (possibly in operations procedures (for instance, business several installments) and medium-sized firms licensing and labor regulations). In practice this is should be expected to comply with the general often more challenging than it may sound; for system (with some simplifications, for example, less example, credible transfer mechanisms may be frequent VAT payments). Special schemes for required to compensate local governments for certain hard-to-tax sectors may be useful tools to foregone revenues. consider. A new design of instruments is often necessary to Linking the costs and benefits of make administrative improvement possible, but formalization--offering "carrots" insufficient without reform of day-to-day administration. Perceptions need to be changed on Given that operating (in)formally is based on a all sides to build a culture of compliance. Better rational and strategic decision, it is necessary to services, outreach, and integration of the private creatively link the costs of formalizing to the sector into the reform process can go a long way in existing and new benefits of formal status. Tax building trust between small contributors and tax reforms should be accompanied by a plan to provide authorities. In addition, existing and newly created information and basic business services, such as benefits of formality need to be linked to tax bookkeeping and marketing. It may be worthwhile compliance. to consider establishing an institution to combine simplified compliance with the provision of some targeted services. This gives informal businesses a single point of contact with the state. IN PRACTICE BUSINESS TAxATIoN 6 Endnotes References IN PRACTICE 1 Because of the small revenue potential of Engelschalk, Michael. 2007. Designing a Tax System the small and medium-sized business sector, for Micro and Small Businesses: Guide for Practitioners. The IN PRACTICE note series many presumptive regimes were introduced Washington, D.C. is published by the Investment without the necessary resources to properly Climate Department (CIC) of the administer small taxpayers. As a result, tax Foreign Investment Advisory Service. 2007. Tax World Bank Group. It discusses bills for contributors below the large taxpayer Compliance Burden for Small Businesses: A Survey of practical considerations and threshold often remained negotiable, with the Tax Practitioners in South Africa. World Bank unsurprising result of widespread corruption. approaches for implementing Group, Washington, D.C. 2 Private tax collection dates back to the Roman reforms that aim to improve Empire when individuals bid for the right to Foreign Investment Advisory Service. 2006. Survey the business environment. The collect taxes in a territory and subsequently Analysis Report of Informal Economic Activity in findings, interpretations, and attempt to cover their costs. A more common Sierra Leone. World Bank Group, Washington, conclusions included in this note arrangement today is for private firms to D.C. are those of the author and do not collect taxes on behalf of the state for a set fee. necessarily reflect the views of the 3 See: Stella (1992). A good example of such International Tax Dialogue. 2007. "Taxation of a privatization of administrative functions is Small and Medium Enterprises ­ Background Paper Executive Directors of the World the recent decision to outsource the collection for the International Tax Dialogue Conference." Bank or the governments they of taxpayers' debts to private agencies in Buenos Aires. represent. the United States. Similarly, some countries (Mozambique, Singapore) rely on private Kenyon, Thomas, and Kapaz Emerson. 2005. "The agents to administer customs systems. Informality Trap." Viewpoint series, Note 301, About the Investment 4 Organisation for Economic Co-operation and World Bank Group, Private Sector Development Climate Department Development. Vice Presidency, Washington, D.C. Stella, Peter. 1992. "Tax Farming ­ A Radical CIC assists the governments Solution for Developing Country Tax Problems." of developing countries and IMF Working Paper No. 92/70. Washington, D.C. transition economies in reforming their business environments, with emphasis on regulatory simplification and investment generation. CIC relies on close collaboration with its donors and World Bank Group partners-- International Finance Corporation (IFC), the Multilateral Investment Guarantee Agency (MIGA), and the World Bank--to leverage value and deliver tangible results for client governments. CIC is the operational center for IFC's Business Enabling Environment Advisory Services and FIAS, the multi-donor investment climate advisory service of the World Bank Group. IN PRACTICE BUSINESS TAxATIoN 7 www.FIAS.NET