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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
THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency
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
THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency
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
THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency
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
THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency
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
THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency
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
THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency
• 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
THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency
• 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
THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency
• 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
THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency
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
THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency
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
THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency
• 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
THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency
• 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%
THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency
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
THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency
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
THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency
• 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
THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency
• 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?
18
THE WORLD BANKWorld Bank Group Multilateral Investment Guarantee Agency
• 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
19