Tax and Growth:
The SME case
Richard Stern
FIAS-Investment Climate Team for Africa
World Bank-IFC
Washington, DC
December 14, 2006
1
Outline
• Tax and growth???? What’s that about?
• Why should we care about taxing SMEs? What
are the tools available?
• Setting the stage: The Framework of Analysis
• First cut results—what do they mean?
• What’s next?
2
Shifting lenses to deal with tax
Traditional Revenue Goal
• Raise Revenue for
government
expenditure
Development/Growth
Goals
• Create a “culture
of taxation”
regularization of
the rule of law
• To increase the
size of the formal
sector
• To promote growth
3
Tax and the business climate
• Tax regimes affect international
competitiveness
• Rates influence foreign investor decisions
• A stable, transparent, even-handed tax
regime is perceived by investors as a sign
of established rule of law
• Tax regime is a pillar of the legislative and
regulatory system
• Tax compliance facilitates economic
activity (can be part of the value chain)
4
Why is it so hard to develop a good
system to appropriately tax SMEs?
• Low levels of capacity and infrastructure to
create and administer, and strengthen a tax
regime
• Weak information base to administer taxes
• Shifting Tax base: movement of firms in and
out of the informal sector
. . and revenue authorities have neither the
resources nor the motivation to concentrate
on SMEs for revenue generation
5
Issues facing SMEs
Where does taxation fit in?
6
Benefits from paying taxes
Again, it’s all about formality and of course,
GROWTH
SMEs which formalize grow faster due to better
resources, access to credit, access to markets. . .
• The rigor of filing tax returns forces firms to use
accounting techniques which gives them better
supervision of business
• The right tax regime offers benefits to larger firms,
which is an implicit incentive for a firm to grow.
. . . but most SME—especially informal--don’t know
about these benefits.
7
An introduction into SMEs
• In the 1950s to 1970s, SMEs were
perceived as marginal to mainstream
activity
• Typically cast as habitual avoiders and
evaders
• In the early 1980s the service sector took
off and represented a higher and growing
proportion of GDP in many countries
• Small businesses accounted for much of
this growth, creating employment &
efficiently utilizing capital in the process
8
Informality: the key SME issue
• In developed economies, most SMEs are
formalized; specific reform measures include
simplification and reduction in compliance
burden.
• In developing economies the task is more
difficult in that SMEs are not generally
compliant (through ignorance as well as
intent) nor are they easily located by the tax
administration. Most operate within the
informal sector
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The Informal Economy:
some numbers
Africa - Informal Economy as a Percentage of GNP, 1999/2000
60.00
50.00
40.00
30.00
20.00
10.00
10
Obstacles to Taxing SMEs
in the Informal Sector
• inconspicuous to tax administration.
• Largely cash businesses – inadequate
accounting records and audit trail.
• Complicated tax systems and numerous
processes (licensing etc.) make it difficult
and expensive for start-up firms to act in
good faith.
• In developing countries, SMEs are rarely
excluded from the tax base but are rarely
properly attended to by the Ras.
• Presumptive taxes proliferate and are rarely
fixed or regularly adjusted
11
Measuring the effects of tax on a
firm’s ability to grow:
Diagnostic tools
12
Diagnostic tools we use so far
• METR to determine the relative tax burden
and to assess the impact by instrument
• In addition to determining the tax burden,
drill down to determine the “value chain of
compliance” (compliance cost survey)
13
A quantitative measure:
METR
METR is a summary measure of the effective
rate of tax imposed on the rate of return (ROR)
generated by the last, or marginal, unit of
capital a firm invests in
. . .in English, it sums up the total fiscal
liabilities incurred by a firm and subtracts any
benefits, incentives, or fiscal relief to yield a
number which describes the “weight” of the
tax system on a firm
14
The Marginal Effective Tax Rate
(METR) on Capital: The “NUMBER”
• A METR of 23% means that taxes account
for 23% of the before-tax (net of
depreciation) rate of return on a marginal
investment (one that just generates the
required after-tax hurdle rate of return)
– 23% of the before-tax rate of return on a
marginal investment is required to
cover its taxes
15
What it does and what we do
with it
• The METR instrument enables us to
compare the tax burden within countries
by sector, as well as between countries
• It enables us to pinpoint which
instruments and rates are driving the
results, and is a useful diagnostic tool
• It is a vehicle for simulating policy
changes, and allows us to adjudicate the
effects on business.
16
What else we use with METR
When doing METRs, we conduct firm
interviews and have developed
compliance cost surveys to determine and
assess:
• Whether or not the instrument is used in
practice by sector
• How administration works (or doesn’t
work)
• Additional “instruments” and issues in
place not specified by law
17
Some results from Africa
18
METRs in Selected AFR Countries
(Data from FIAS Studies 2006, category avgs)
in percent
Country
Sector
Zambia
Rwanda
Madagascar
Tanzania
South
Africa
Manuf Tourism
5
5
AG
29
24
15
14
14
15
10
7
15
20
27
28
23
Min
Small
Business
(No VAT)
38
29
29
0
15
11
23
25
34-51
60
30-32
31
10
22-32
Fin
30
19
What the Qualitative Analysis
told us
The other “instrument”, firm interviews,
confirmed the METR results
• In addition to the financial burden, SMEs
in all countries report that time
compliance costs are excessively high,
adding to the total cost of paying taxes.
• With compliance costs high, and the
perception that firms don’t “get” anything
in return for paying taxes,
Thus, incentives to operate informally are
high.
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and, weak tax administration for
SMEs compound the problem
• Revenue authorities have neither the resources
nor the incentive to focus on SMEs
• As a result, firms tell us the application of the
tax laws are variable and inconsistent at best
• Firms complain refunds (eg: for overpayment of
presumptive taxes) rarely come and usually not
without an audit.
21
Compliance Costs: New Zealand
Size of firm
(Turnover $)
Average compliance costs
(as percent of turnover)
< 30,000
30,000 – 100,000
100,000 – 250,000
13.4
6.5
4.2
250,000 – 500,000
500,000 – 1 million
1 million – 2 million
2.4
1.5
1.2
2 million – 10 million
10 million – 50 million
more than 50 million
0.4
0.09
0.03
22
What is being done so far?
23
Old solutions
•
•
•
•
•
Simplifications (process, forms etc.)
Exemptions
Raising of thresholds
Presumptive methods
Standard assessments for groups in
specific sectors or businesses
• Estimated or minimum taxes (generally
based on turnover)
• Flat rate or equalization rates in lieu of
VAT
24
Some examples in AFR
Sierra Leone
Standard Tax – standard assessments for certain categories
of taxpayer
Alternative Chargeable Business Income – 15% of 10%
of turnover – minimum tax
Advance Tax – administratively burdensome
Zambia
3% Turnover Tax – estimated tax
Where turnover does not exceed K200m pa (U$40k) must
utilize this regime
No option to join normal tax regime and may not
participate in VAT regime
25
Some more examples in AFR
Tanzania
Turnover Tax – standard assessment
Where turnover does not exceed TSH20m pa (U$16k) must
utilize this regime
No option to join normal tax regime and not compelled to
participate in VAT regime where turnover does not exceed
TSH40m pa (U$32k) but may choose to
Rwanda
4% Turnover Tax – estimated tax
Where turnover does not exceed RWF20m pa (U$38k) may
utilize this regime
May participate in normal tax regime and may
opt in to VAT regime at any time
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We can do much better
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Design elements for
implementation
Implementation on both sides of the street
• For the entrepreneur, the system has to be
simple, easy to comply with, and
accompanied by capacity building
• System has to encourage growth of
business (need advantages to graduation)
• For the authorities, the system must not
require disproportionate administration
• A small taxpayer unit, donor funded, to
focus on SME issues
28
More guidelines
Current Thinking Regarding the “Informal” Regime
• Simplify and streamline our normal tax regime
• Any regime to be implemented should not
became a “refuge” where small business
stagnates – there must be sufficient incentive for
small business to want to “outgrow”
• Instead of presumptive taxation, maybe a single
tax along the lines of a “business license”
29
Who can do Implementation?
Possible Solutions, all requiring inter-donor
coordination
• Together with the IMF and the IFC/WBG,
implement SME taxation schemes based on
country experience
• Design information dissemination and
sensitization programs for SME tax policy
• A radical idea: implement a small business
tax unit (like the LTUs) to focus on SME issues
30
The way forward: joint solution
design and joint implementation
To date, we now have intra-Bank group and interdonor mechanisms for coordination
• Within the WBG, PREM, SME, IFC (FIAS) all
working together, with regular meetings
• International Tax Dialogue =
WBG + IMF + IADB + OECD
• Upcoming events include Summit of AFR Tax
practitioners in Livingstone (March 2007)
• ITD conference on SME taxation (Oct. 07)
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