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Tax and Growth:

The SME case

Richard SternFIAS-Investment Climate Team for Africa

World Bank-IFCWashington, DC

December 14, 2006

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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?

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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

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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)

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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

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Issues facing SMEs

Where does taxation fit in?

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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.

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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

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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

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Africa - Informal Economy as a Percentage of GNP, 1999/2000

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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

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Measuring the effects of tax on a firm’s ability to grow:

Diagnostic tools

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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)

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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

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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

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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.

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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

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Some results from Africa

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in percent

CountrySector Manuf Tourism AG Fin Min

Small Business

(No VAT)

Zambia 5 5 10 30 0 25

Rwanda 29 14 7 38 15 34-51

Madagascar 24 14 15 29 11 60

Tanzania 15 15 20 29 23 30-32

South Africa 27 28 23 31 10 22-32

METRs in Selected AFR Countries (Data from FIAS Studies 2006, category avgs)

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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.

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Compliance Costs: New Zealand

Size of firm

(Turnover $)

Average compliance costs (as percent of turnover)

< 30,000 13.4

30,000 – 100,000 6.5

100,000 – 250,000 4.2

250,000 – 500,000 2.4

500,000 – 1 million 1.5

1 million – 2 million 1.2

2 million – 10 million 0.4

10 million – 50 million 0.09

more than 50 million 0.03

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What is being done so far?

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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

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Sierra LeoneStandard Tax – standard assessments for certain categories of taxpayerAlternative Chargeable Business Income – 15% of 10% of turnover – minimum taxAdvance Tax – administratively burdensome

Zambia3% Turnover Tax – estimated taxWhere turnover does not exceed K200m pa (U$40k) must utilize this regimeNo option to join normal tax regime and may not participate in VAT regime

Some examples in AFR

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Some more examples in AFR

TanzaniaTurnover Tax – standard assessmentWhere turnover does not exceed TSH20m pa (U$16k) must utilize this regimeNo 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

Rwanda4% Turnover Tax – estimated taxWhere turnover does not exceed RWF20m pa (U$38k) may utilize this regimeMay 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

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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”

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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

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The way forward: joint solution design and joint implementation

To date, we now have intra-Bank group and inter-donor 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)