NOTE NUMBER 349 Public Disclosure Authorized viewpoint PUBLIC POLICY FOR THE PRIVATE SECTOR FEBRUARY 2016 Public Disclosure Authorized Small Business Tax Regimes Jacqueline Coolidge and What Surveys Reveal about Tax System Use and Abuse T r a d e a n d C o m p e t i t i v e n e s s G l o b a l P r a ct i c e Fatih Yılmaz S i mpl i fi e d tax re gi me s for mi c ro an d smal l e n te rpri se s i n de ve l opi n g Jacqueline Coolidge (jcoolidge@schoolbench c ou n tri e s are i n te n de d to fac i l i tate vol u n tary tax c ompl i an c e . .com) is a former World H owe ve r, su rve y e vi de n c e su gge sts th at smal l bu si n e ss taxati on base d Public Disclosure Authorized Bank staff member, and is on si mpl i fi e d bookke e pi n g or tu rn ove r i s some ti me s pe rc e i ve d as too now a consultant working primarily on tax, legal c ompl e x for mi c roe n te rpri se s i n c ou n tri e s wi th h i gh i l l i te rac y l e ve l s. and regulatory reforms to Ve ry si mpl e fi xe d tax re gi me s n ot re qu i ri n g an y books or re c ords te n d improve the investment climate/business enabling to be ove rl y popu l ar bu t pron e to abu se . S yste m re forms wou l d environment. Fatih re qu i re more pre c i se tai l ori n g of th e si mpl i fi e d re gi me s to th e i r Yılmaz (fatih.yilmaz@ tcmb.gov.tr), a former targe t be n e fi c i ari e s, c ou pl e d wi th stron g c ompl i an c e man age me n t to World Bank consultant, de te c t an d de te r abu se . is currently an Economist The overall objective of simplified taxation for A review of the operation of simplified tax at the Central Bank of micro and small enterprises (MSEs) in develop- regimes using results from the World Bank’s the Republic of Turkey. Research for this note was ing countries is generally to facilitate voluntary Tax Perception and Compliance Cost Surveys tax compliance and remove obstacles in mov- in six developing countries revealed notable dif- Public Disclosure Authorized supported by the World Bank Group’s Trade and ing toward business formalization and growth. ferences in the level of system acceptance and Competitiveness global While the design of such simplified taxes varies use. In addition, the results showed evidence practice. by country, two main types of simplified regimes regarding risks of system abuse, depending on can generally be distinguished: the regime’s design characteristics and applica- THE WORLD BANK GROUP (1) Very simple lump sum or fixed amount tion as well as country-specific characteristics. taxes (also called “patents”), usually targeted at Despite the operation of a special simplified microenterprises, taking into account that such tax regime, in some cases small firms may be businesses are often operated by illiterate or deterred from formalizing due to perceived semi-literate entrepreneurs. excessive tax burdens, compliance costs, and (2) Presumptive profit taxes or single taxes risks (including risks of punishment for real or (replacing a number of other taxes) based on alleged non-compliance). In other cases, though, turnover, either with the tax liability calculated as the overly generous design of a simplified regime a percentage of turnover or with net profit calcu- may deter businesses from reporting growth lated by applying a standardized cost deduction and “graduating” into the general tax regime. from turnover to account for business expenses. Such risk factors and business attitudes have to S mall B us i ness T a x R eg i mes W h a t S u r v e y s R e v e a l a b o u t T a x S y s t e m U s e a n d A b u s e be taken into account by policy makers in the hard to monitor. The risk of FTR abuse for tax system design exercise and should be updated revenue management increases with the size of over time as conditions change. businesses using the regime, so clear rules need to be introduced (and enforced). This will restrict Simplified MSE tax regimes in system access to a core target group of subsis- survey countries tence-level enterprises (usually assumed to be The World Bank surveys were conducted in operated by illiterate or semi-literate entrepre- Albania, Burundi, Nepal, South Africa, Ukraine, neurs). Survey responses strongly suggest, how- and the Republic of Yemen. They collected infor- ever, that this principle is frequently not followed 2 mation about the use and abuse of simplified in practice, and fixed tax regimes were often regimes, along with data on firm characteristics reported to be used by small or even medium- (size, sector, location, and so on).1 The countries sized businesses, resulting in a risk of declining had different kinds of simplified MSE tax regimes taxpayer participation in the general tax regime. at the time of the survey (table 1). In some transition and developing countries, where fixed tax regimes initially were introduced Although popular, compliance management is with the objective of minimizing the burden on challenging for fixed tax regimes low-capacity tax administrations facing rapid Fixed tax regimes (FTR) consistently show very growth of the taxpayer population in the micro high levels of usage, as they typically combine business segment, the high popularity of the a rather low tax burden with minimal compli- regimes among a large number of constitu- ance costs. Overall, the reported use of fixed tax ents made them politically difficult to remove regimes among those businesses eligible in the (Engelschalk 2004; Bird and others 2008). This survey countries was 98 percent in Albania, 92 occurred even when the original rationale for percent in Burundi, 88 percent in Nepal, 93 per- introducing the system became less important cent in Ukraine (among sole proprietors), and as tax administration capacity was strengthened. 96 percent in the Republic of Yemen. In practice, fixed tax regime thresholds are However, very low or even non-existent report- difficult to enforce because of the low documen- ing requirements render system eligibility criteria tation requirements of these regimes. The survey Table Simplified MSE tax regimes in survey countries 1 Fixed tax regime for Simplified tax regime for Country (survey year) micro businesses small business Key eligibility criteria Yemen, Rep. (2007) Yes Turnover tax Eligibility for a fixed tax regime is based on reported inability to keep books; fixed tax liability based on negotiations. Ukraine (2007) Yes Turnover tax Fixed tax regime accessible for sole proprietors only; turnover tax only for legal entities. Fixed tax threshold is turnover below Ukrainian Hryvnia (UAH) 3 million (US$98,800), with not more than 20 employees. The turnover tax threshold is turnover below UAH 5 million (US$164,700), with a maximum of 50 employees. Burundi (2010) Yes Net income taxation based on Fixed tax threshold is Burundian Franc (BFr) 15 million (US$12,000) for simplified accounting. accommodation and services; BFr 20 million (US$16,000) for trade and manufacturing. Nepal (2010) Yes No Regime threshold is Nepalese Rupee (NR) 2 million (US$25,000). Eligible firms could pay fixed tax and also register for the value-added tax (VAT). South Africa (2011) No Turnover tax Regime threshold is South African Rand (R) 1 million (US$86,100). Albania (2012) Yes Net income taxation based on Fixed tax regime for businesses with turnover below Albanian Lek (LEK) simplified accounting. 2 million (US$15,900). Simplified accounting for businesses with turnover below LEK 8 million (US$63,500) (thus, substantially exceeding the VAT threshold of LEK 5 million). Source: Coolidge and Yılmaz 2015. evidence suggests that the risk of fixed tax regime situation in Burundi, the simplified accounting abuse increases in two cases in particular: (i) the regime is not considered really attractive; there- fixed tax regime threshold is not clearly defined fore, such migration is not particularly popular. or is inappropriately high; and (ii) the absence of an intermediate simplified small business tax Small business turnover tax regimes not regime forces small businesses to avoid growing, necessarily popular among targeted either by staying below the turnover threshold or businesses by under-reporting turnover to tax authorities. Only three of the countries surveyed (South An example of the first case occurred in the Africa, Ukraine [regime limited to legal enti- Republic of Yemen, which had no clear FTR ties], and the Republic of Yemen) operated turn- threshold but allowed any business that did not over tax (TOT) regimes for small businesses, keep books of account to apply the fixed tax.2 The so the country analysis is therefore limited. regime permitted the business to initially negoti- However, substantial evidence exists to coun- ate its tax liability with the tax authority. This tax ter the frequent assumption that TOT regimes liability was increased by a fixed amount each year, automatically become a widely used compli- resulting in a low tax liability with long-term pre- ance simplification tool for small businesses. dictability. The survey provided strong evidence In fact, existing TOT regimes were ultimately that the great majority of businesses used the fixed not particularly popular in any of the countries tax regime irrespective of the actual bookkeeping surveyed. Use of TOT among those eligible was practice and capacity; in fact, about half of busi- only around 7 percent in South Africa, under nesses reporting usage of the fixed tax regime 30 percent in Ukraine, and under 5 percent in also reported keeping regular books. Fortunately, the Republic of Yemen. such de facto “negotiated” tax regimes with non- The survey analysis suggested a variety of rea- transparent eligibility criteria are being phased sons why TOT regimes attract fewer taxpayers out in most developing countries. than might be expected. The second alternative was observed in In the case of Ukraine, the tax rates of the TOT Burundi (as of the time of the survey, before it regime are relatively high: the rate is 10 percent enacted reforms). Small businesses with turnover when the regime is applied to substitute for both above the fixed tax regime threshold could, in income tax and VAT, and 6 percent when it sub- principle, apply simplified accounting rules; how- stitutes only for income tax. Thus, the tax burden ever, these accounting simplifications generally resulting from the application of the regime risks were perceived as not very different from the being viewed as unattractive for industries with regular tax regime. Seeing no significant advan- relatively tight profit margins. In addition, there tages, very few businesses (less than 1 percent) is some evidence (from sources other than the ever used this approach. Therefore, when faced Tax Perception and Compliance Cost Surveys) with a choice between migrating downwards into that system competition has occurred between the fixed tax regime with very low effective tax the TOT regime for legal entities and the fixed rates and a very simple administration, or com- tax regime for individual entrepreneurs with a plying with the regular tax regime, many small comparatively much lower tax liability. Although and even medium-sized businesses with a turn- there was not much survey evidence of large-scale over (as reported in the survey) higher than the abuse of either simplified regime, the possibility FTR threshold nevertheless reported using the of reducing tax liability by changing the legal FTR. Survey data suggest that about half of all status of the business to operate as sole proprietor tax-registered businesses used the FTR, although rather than a legal entity seems to have contrib- only 36 percent were actually eligible for it. uted to more take-up of the fixed tax regime at A similar disincentive for migrating out of the the expense of the TOT regime.3 fixed tax regime exists in Albania. All small busi- A clear case of system competition could be nesses in Albania are allowed at the beginning of observed in the Republic of Yemen, where the the year to opt for the FTR. Only when at some lack of proper limitations in applying the fixed point during the year their turnover exceeds tax regime eroded the tax base of the TOT the FTR threshold are they expected to shift to regime. As a result, in 2007 less than 5 percent of the simplified accounting regime. Similar to the businesses opted for turnover taxation, primarily those businesses engaged in international trade were in fact estimated to be eligible on the basis (and not allowed to use the fixed tax regime). of turnover.4 In South Africa, the Revenue Service had initially considered setting different TOT rates Abuse risks of presumptive tax regimes and for industry sectors depending on their average ineffective enforcement profitability. However, a closer examination of Survey evidence suggests that fixed tax regimes existing data did not reveal statistically significant generally have a higher risk of abuse, that is, use differences in average profit margins between by non-eligible businesses, than TOT regimes. sectors (mostly because the variance within each The evidence is clearest in the cases of Burundi 4 sector was very high). The Revenue Service opted and Nepal, but less obvious in the Republic of for a uniform progressive rate structure rang- Yemen due to the non-transparent FTR thresh- ing from 1 percent up to 7 percent of turnover. old. Abuse levels among FTR users ranged from Although the TOT liability for the majority of about one-quarter in Nepal to almost half in the small businesses is considerably lower than in Republic of Yemen, whereas abuse rates for those Ukraine, adoption of the regime was much less using TOT was below 20 percent in both South than anticipated. Registration numbers, which Africa and Ukraine (table 2). had been expected to exceed 40,000 within the The general tax policy approach, allowing low- first two years of system application, never rose capacity, poverty-level microenterprises to pay a above 8,000. The great majority of taxpayers were small fixed tax amount without any bookkeeping clustered at the lower end of the distribution, requirements and allowing small businesses to thereby paying the lowest TOT rates. pay a simplified turnover tax based on minimal Survey evidence indicates that an important bookkeeping standards, appears reasonable. lesson of the South African example is the critical However, the high abuse rate, in particular of importance of taxpayer outreach and informa- fixed tax regimes, should be a matter of concern tion to explain the simplified tax regime and in practice. While the revenue potential of fixed promote its use, particularly in encouraging taxpayers is low, system abuse and the extension informal businesses to become tax compliant. of a fixed tax regime to the taxpayer population In South Africa, a deficient communications above subsistence level create perverse incentives campaign associated with the introduction of — a risk both for revenue generation and busi- the new TOT in 2008 failed to encourage many ness growth and development. Tax policy mak- businesses to make use of the new regime. In a ers and administrators need to consider how to 2011 survey, the majority of micro, small, and mitigate these risks. On the tax policy side, the medium enterprises (MSMEs) expressed confu- definition of sufficiently low and properly verifi- sion about whether they were even eligible for able regime thresholds is a critical design task; on the regime. Over 40 percent responded “unsure” the administrative side, compliance management or “don’t know,” and almost half (46 percent) activities and control of (major) system abuse answered “no” — even though about 70 percent should extend to the micro-business segment. Table Summary of estimates of use and abuse of simplified regimes among business taxpayers 2 Percentage of all Percentage of all Percentage of firms Estimated abuse Estimated abuse Type of simplified firms that are eligible firms that use eligible for the regime (percentage of (percentage of firms Country regime analyzed for the regime the regime that use it all firms) using the regime) Yemen, Rep. FTR 47 94 96 47 48 Burundi FTR 36 50 92 14 34 Nepal FTR 86 80 88 4a 26a Albania FTR 58 58 98 < 2a <1a South Africa TOT 69 7 8 1 18 Ukraineb TOT 60 34 29 5 16 Source: Coolidge and Yılmaz 2015. Note: FTR abbreviates fixed tax regime; TOT abbreviates turnover tax. a. Abuse of the FTR in Albania and Nepal was probably substantially higher, taking into account average estimated levels of under-reporting turnover in the survey. b. Non-agricultural legal entities. In practice, compliance management fre- percent) and have net incomes at or near the quently seems insufficient even in the small poverty threshold. Even for these countries, how- business segment. Evidence suggests that tax ever, it may be beneficial to place more emphasis administrations in almost all countries sur- on the design of simplified regimes appropriate veyed failed to put into place risk-management for small businesses yielding incomes above pov- strategies targeted at detecting abuse of sim- erty levels. Such businesses should be required to plified tax regimes. Instead of concentrating keep basic books (for example, reports of daily scarce audit resources on cases of high system sales, although not necessarily the details of every 5 abuse risks, most of the surveyed countries transaction) and to pay tax based on turnover. seemed to follow an approach of merely ensur- Thresholds should be set by taking into account ing relatively broad audit coverage of the MSE correlations between turnover, on the one hand, segment. In line with international good prac- and literacy and (roughly) estimated net income, tice, the percentage of businesses audited in on the other. The thresholds should be revised the MSE segment was generally lower than periodically to keep them in line with their target in the large and medium business segments. populations. At the same time, small businesses However, a risk-based small business audit should be offered training in basic bookkeeping approach seemed to be lacking. and preparation of simple tax returns and other Surveys identified no statistically significant aspects of realistic tax compliance. correlation between the level of inspections and The case of South Africa illustrates the need the level of system abuse. for targeted outreach and education campaigns aimed at micro and small enterprises so that they Conclusion can gain a better understanding of the options It has been well accepted theoretically that pre- available to them. The emphasis in South Africa sumptive taxation should be designed to address has arguably been too heavily in favor of “deter- the highest priority problems of taxing MSMEs rence” of businesses that might be ineligible to in developing and transition countries. These use the regime. In this context, the Revenue priorities are likely to change as countries grow Authorities’ information has probably overem- and capacity improves both in the public and the phasized the topic of ineligibility, while not suffi- private sectors. Simplified tax regimes should be ciently informing and encouraging eligible small periodically reformed to ensure they continue to businesses about the opportunity and benefits of address priority needs under changing circum- the TOT regime. stances. Surveys of small businesses focusing on More broadly, it appears that in many cases education levels, bookkeeping practices, use of “simplified” regimes that require bookkeeping bank accounts, and similar objective variables tend to be perceived as still overly complex and may help inform the key parameters of simpli- therefore unpopular. These will require more fied regimes. encouragement. “Patent” or fixed-tax regimes Data from taxpayer surveys suggest that fixed appear to be overly popular, but prone to abuse, tax regimes may cause significant damage in erod- and may need to be more restricted. Compliance ing the base of the general or turnover-based simplifications for small businesses which are small business tax regimes, which needs to be limited in scope to just minor simplifications in taken into account in a cost-benefit analysis of the tax accounting requirements — but do not these regimes. also simplify tax calculation and payment obli- Despite the risk, the data from Burundi, gations — are not seen as a real relief, and they Nepal, and the Republic of Yemen suggest a seem to be poorly accepted. Beneficial reforms continuing need for a fixed-tax regime for true would require more precise tailoring of the microenterprises in low-income, low-capacity simplified regimes to their target beneficiaries countries, as many such businesses are unable (which will probably shift over time), coupled to practice bookkeeping (for example, in cases with well-targeted compliance management to where national adult literacy rates are under 90 detect and deter abuse. S mall B us i ness T a x R eg i mes W h a t S u r v e y s R e v e a l a b o u t T a x S y s t e m U s e a n d A b u s e Notes ———. 2012b. “Le Coût de la Mise en Conformité avec 1. For a complete description of the surveys, see la Réglementation Fiscale du Secteur Formel et la Coolidge (2012). The surveys all included at least sev- Perception de la Fiscalité par le Secteur Informel au eral hundred active business taxpayers, and were based Burundi.” viewpoint on a stratified sample from the relevant tax authorities. ———.2012c. Nepal Tax Compliance Cost Survey The detailed draft country reports are available from Report. Available at: https://www.wbgin is an open forum to the authors on request. vestmentclimate.org/publications/loader encourage dissemination of 2. This was the case at the time of the survey; more re- .cfm?csModule=security/getfile&pageid=33942 public policy innovations cently, the Republic of Yemen has enacted fundamental ———. 2009. The Costs of Tax Compliance in Ukraine. for private sector–led and reforms of its MSME tax regime. Available at: http://www.ifc.org/wps/wcm/connect market-based solutions for 3. There is also evidence that many businesses use other /725f0b804b5f7ae59f06bf6eac26e1c2/UTCCS_eng development. The views ploys, such as contracting of “sole proprietors” instead .pdf?MOD=AJPERES&CACHEID=725f0b804b5f7ae5 published are those of the of employees, or splitting up a business into two or 9f06bf6eac26e1c2. authors and should not be more entities in order to qualify for the presumptive ———. 2008. “Yemen Tax Cost of Compliance Survey.” attributed to the World regime (IFC 2009). Unpublished note. Bank or any other affiliated 4. A small proportion of these generally eligible busi- Khwaja, Munawar Sultan, Rajul Awasthi, and Jan organizations. Nor do any nesses could indeed have been legally excluded, which Loeprick. 2011. Risk-Based Tax Audits: Approaches and of the conclusions represent could be based on other criteria limiting system acces- Country Experiences. Washington, DC: World Bank. official policy of the World sion in case of certain activity types, or close links to Smulders, S., M. Stiglingh, R. Franzsen, and L. Fletcher. Bank or of its Executive larger businesses. See Smulders and others (2012). 2012. “Tax Compliance Costs for the Small Business Directors or the countries Sector in South Africa.” EJournal of Tax Research they represent. References 10(2):182–226. Bird, Richard M., Jorge Martinez-Vazquez, and Benno To order additional copies Torgler. 2008. “Tax Effort in Developing Countries contact Jenny Datoo, and High Income Countries: The Impact of Corrup- managing editor, tion, Voice and Accountability.” Economic Analysis Room F 5P-504, and Policy 38(1): 55–71. The World Bank, Coolidge, Jacqueline. 2012. “Findings of Tax Compli- 1818 H Street, NW, Washington, DC 20433. ance Cost Surveys in Developing Countries.” eJour- nal of Tax Research 10(2): 250–87. Telephone: Coolidge, Jacqueline and Fatih Yılmaz. 2015. “Simpli- 001 202 473 6649 fied Small Business Tax Regimes in Developing Email: Countries: Empirical Evidence of Use and Abuse.” jdatoo@worldbank.org In Tax Simplification, edited by Chris Evans, Richard Kreve, and Peter Mellor. Alphen aan den Rijn: Klu- Produced by Carol Siegel wer Law International. Engelschalk, Michael. 2004. “Creating a Favorable Printed on recycled paper Tax Environment for Small Business.” in Taxing the Hard-to-Tax: Lessons from Theory and Practice, edited by James Alm, Jorge Martinez-Vazquez, and Sally Wal- lace, 275–311. Oxford: Elsevier. IFC (International Finance Corporation). 2012a. “Al- bania Tax Compliance Cost Survey.” Unpublished note. This Note is available online: http://www.worldbank.org/fpd/publicpolicyjournal