taxation of small business and fairness issues, tradeoffs, design options global tax simplification...

TAXATION OF SMALL BUSINESS AND FAIRNESS

Issues, Tradeoffs, Design Options

Global Tax Simplification TeamWorld Bank GroupDecember, 2011

THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency

Perception regarding fairness of small business tax systems varies substantially among stakeholders:

• Are small businesses at a comparative disadvantage?• Complaints about “High tax burden”. But what does this mean?

• Small businesses face more operational challenges than larger businesses. Should tax system compensate for these challenges?

• High compliance burden

• Easy targets for corruption and harassment

• Or are small businesses privileged?• More options for hiding income than wage earners

• No requirement to register for VAT

• Option to work in informal sector

• Highly preferential presumptive tax regimes

Small Business Taxation and Fairness: What are the Issues?

2


Business Size and Tax Burden

3

Evidence from Uganda: Actual tax burden as percentage of sales

Risk that medium-sized businesses face a disproportionally high tax burden

Source: Gauthier/Reinikka, Shifting tax burdens through exemptions and evasion: an empirical investigation in Uganda, 2001

2-5 6-25 26-75 76-200 200 +0

2

4

6

8

3.1

5.2

7.4 6.9

2.1

Number of employees


FIAS surveys on barriers to formality and tax compliance cost:

• Firms are well aware of the benefits and disadvantages of operating (in-)formally

• Tax (rates+admin) is seen as a driver of informality • Other dimensions of formality are important and linked to

tax formality decision • Fees, licenses and other nuisance taxes are a non-

negligible burden, especially for small firms • Many firms have tried and failed to formalize: assistance is

needed

Tax and Informality

4


Evidence from Liberia: when would a business consider formalizing

Source: FIAS, Removing Barriers to Enterprise Fomalisation in Liberia, 2007.

Tax as a Reason for Non-Formalization

5

Reduc

ed ta

xes

Reduc

ed a

dmin

bur

den

Reduc

ed c

ost o

f la

bor

Trans

pare

nt p

roce

dure

s

Admin

tran

spar

ency

Tax in

cent

ives

Incr

ease

d go

v pr

essu

re0

20

40

60

80

100Most important stimulant

Top 3 stimulants


When the “cost” of formalization is too high…

6

• Argument that certain level of underground economy boosts economic development.

• But from a fairness point of view tax payment burden is shifted to small number of formal business operators.

the formal economy and can get a “free-ride”

However: more risks, less opportunities (esp. access to finance)

Serious limitations to business growth…

Spurs vicious cycle of “squeezing” the few compliers => ticket price↗

Government is not reaching revenue potential


Compliance costs matter a lot for MSEs!

0 - 5

5 - 1

3

13 -

24

24 -

41

41 -

66

66 -

104

104

- 161

161

- 246

246

- 374

374

- 567

567

- 855

855

- 128

7

1287

- 19

36

1936

- 29

09

2909

- 43

69

4369

- 65

58

6558

- 98

43

0

2

4

6

8

10

12

14

16

18

20

South Africa Ukraine Uzbekistan Armenia India (Bihar) Kenya Georgia

Turnover in 000 USD

Ta

x C

om

plia

nc

e C

os

t a

s a

pe

rce

nta

ge

of

turn

ov

er

Source: Tax Compliance Cost Surveys in Selected Countries 2007-1011


• VAT• Increasing low VAT registration thresholds can considerably reduce

tax related burden on small businesses

• Additional simplifications for medium sized businesses facilitate transition into standard regime

• Accounting• Cash instead of accrual accounting as standard system for small

businesses

• Challenge of coordinating general accounting rules with tax accounting rules

• Income taxation• Administrative simplification vs. rate reduction

• Simple presumptive system for businesses below VAT registration threshold best option in many countries

Some Conclusions from this Analysis

8


• Reach out to informal sector is important

• Support and advice to businesses trying to formalize: prime objective is voluntary formalization

• Increasing taxation costs of informality (e.g. withholding taxes)

• Target audit program not exclusively to tax registered businesses

Some Conclusions from this Analysis II

9


• Exclusion of small businesses from VAT system can reduce compliance costs, but can also result in higher METR.

• Therefore option to register voluntarily is important.

Small Business and VAT

10

South

Afri

ca

Tanza

nia

Namibi

a

Zambia

Leso

tho

Rwanda

0102030405060

Aggregate METRs on Capital: Small Cor-porations

VAT registeredNot VAT registered


Broadening the presumptive tax net is good in principle – but where do these taxpayers really come from?

The popularity of the presumptive tax regime in Ukraine:

Popularity of Presumptive Tax Systems: A Benefit or a Curse?

11


Presumptive Taxation: Simplicity vs. Fairness

12

1 9 17 25 330

500,000

1,000,000

1,500,000

2,000,000

2,500,000 Service Industry (Profit Margin 50%)

Construction(Profit Margin 15%)

Trade (Profit Margin 10%)

Kazakhstan: Comparison of Liabilities for Businesses in Different Regimes with Varying Profit Margins (Individual Entrepreneurs)

Turnover, KZT (in million)Tota

l Tax

Lia

bilit

y KZ

T (In

com

e Ta

x an

d So

cial

Ta

x)

Difference in tax liability at the threshold of 40 million KZT for a high profitability business in the simplfiefd and standard regime


• Single rate turnover systems discriminate against businesses with low profit margins and provide strong migration disincentives for highly profitable SMEs

• Presumptive system design needs to take into account differences in average profit margins

• The challenge of data collection and analysis:

• Little existing information on small business segments

• Audit data not systematically analyzed

• Profit margin analysis difficult to do

Presumptive System Design: Reform Directions

13


• Multiple rate turnover system:

Presumptive taxation in Poland:

Options for a System Redesign (I)

14

Small business category Tax as % of turnover

Retail trade and catering 3%

Manufacturing, construction, cargo transport

5.5%

Services 8.5%

Wholesale trade, car rental, hotels 17%

Liberal professions 20%


Options for System Redesign (II)

15

Simplified taxation through presumptive calculation of business expenses

Country Business expenses as percentage of gross income

Bulgaria 40% for craftsmen and artists25% for liberal professions and civil contract work

Czech Republic 80% for agricultural activities and handicraft60% for trade40% for any other type of activity

France 71% for trade50% for other businesses

Portugal 80% for trade30% for other businesses

Slovak Republic 60% for craftsmen25% for other businesses


Presumptive tax systems are a convenient solution to small business tax problems. However, careful thought should be given to determining when this solution is really needed!

Is an equal treatment of small incorporated and small non-incorporated businesses necessary / desirable?

Taxation of professionals: why not net income taxation?

Presumptive taxation and voluntary VAT registration

The Need for Limitations

16


• Combination of preferential small business tax rate and higher evasion potential is major source of income tax unfairness

• Disproportional contribution of wage earners to PIT revenue collection in many countries

• Example Sweden: Self-employed households spend 5-7% more on food than wage earners with the same reported income

• Example US: Rate of non-compliance is less than 1% for wages, but 57% for sole proprietors.

• Preferential tax treatment of self-employed has negative impact on labor market

The Employee – Self-Employed Discrepancy

17


• Presumptive tax rates have to be set at reasonably high level

• Increased use of withholding taxes?

• Higher penalties?

• More audits?

• Or an extensive public awareness campaign?

• Any other possibilities to reduce evasion possibilities for self-employed (e.g. cash withdrawal tax; obligation to pay by bank transfer; invoice lotteries; whistleblower mechanisms; cash registers)?

What Can be Done?

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• It is important for the tax administration to better understand the small business segment. Dialogue and outreach need to be developed.

• Reducing compliance costs is major contribution to overall fairness of the tax system

• Address disincentives and barriers to business formalization

• Focus of audit and control on major evaders

• Different presumptive tax treatment for trade and services

• Align presumptive tax burden with standard tax regime

• Targeted anti-abuse measures

Summary: A Strategy for a Fair Small Business Tax System

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taxation of small business and fairness issues, tradeoffs, design options global tax simplification...

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