Taxing the informal economy

The Outlook country surveys gather evidence that the “informal economy” – workers and companies operating outside the reach of the law or public administration – is a major obstacle to broadening the tax base and collecting direct taxes. Informality is indeed widespread in developing countries, but highest in sub-Saharan Africa (Table 2). This poses a wide range of economic challenges: not only are taxes not collected, but informal firms are also often less productive and there are no labour and social protection schemes for workers. In short, high informality leads to lower economic growth and greater social exclusion. Informality often arises where the costs of legal employment outweigh the benefits for producers, employers or employees. If entry costs into a regulated economy are unaffordable, people and businesses are forced to remain outside the system (Jütting and de Laiglesia, 2009).

Source: Jütting and de Laiglesia (2009).

Fiscal policy in developing countries must consider capacity, incentives and segmentation. In countries where the informal sector comprises more than half of the economic activity, the question arises as to how governments can pursue fiscal policy in terms of both taxation and expenditure. On the one hand, more firms in the formal sector means increased tax collection and social security contributions for the state. On the other hand, more people covered by social security means increased liabilities for governments as employees become eligible for health insurance, pensions and other benefits where offered.  In addition, the increase in tax revenue from formalising informal firms may be smaller than expected. Indeed informal firms that enter the system are often too small and too poor to make sizeable contributions. However, value-added and sales taxes could still produce a notable increase in tax collection as these also indirectly tax informal activities (Latin American Economic Outlook, 2009).

Ghana has tried a new approach to tax collection. The Internal Revenue Service negotiated an arrangement with the Ghana Private Road Transport Union (GPRTU) to use the union as a tax collection agent under the “Identifiable Groupings Taxation” (IGT) scheme. Simple and easy to administer, IGT calls for small and affordable taxes to be collected daily or weekly from both formal and informal union members. GPRTU retains 2.5% of revenues as an incentive to maximise collection. Although relatively successful, this attempt to make inroads into the informal sector has come at a high cost and created opportunities for corruption. So, while more tax is raised, the amount is below potential (Joshi and Ayee, 2002).

The quality of tax policies and tax administration also plays an important role. Complex tax codes and high compliance burdens imposed by an inefficient tax administration are powerful incentives for small enterprises to remain informal. For example, country surveys reveal that, in Uganda and Zambia, bureaucracy and corruption are identified as barriers against entering the formal sector. While in Togo, informal firms state that complex registration procedures impede their entering the formal sector. Figure 17 plots the number of hours per year it costs businesses to pay taxes. On average, it takes fewer hours to pay taxes in Africa than in Latin America, but more than in the Pacific, Asia and OECD countries. However, on the left hand of the scale are countries where the compliance burden is exceptionally high. See OECD-CTPA (2008) for an extensive discussion of the tax compliance burden.

Tax administration capacity

Administrative capacity constraints have been highlighted throughout the Outlook country surveys as a major obstacle to improving tax policy in Africa. The administrative constraints are such that they limit policy options.

• For example, in theory, relying more on income tax and exemptions on basic consumer items would enable more redistribution of resources. But where administrative capacity is weak, personal income tax is less progressive than expected. Firstly, only wages, mostly earned in large private firms and in the public sector, are taxed. Secondly, personal income earned on capital is typically not taxed. Capital, real estate income and other revenues of high earners in the informal sector are thus outside the reach of tax administration.
• For a variety of reasons, VAT exemptions in Africa are often regarded by experts to be regressive (Box 1). Strategies that copy those used in countries with high administrative capacity can be counter-productive. In Morocco, before a 2005 fiscal reform, generous VAT exemptions undermined the potential of VAT introduced in 1986.

The vast majority of countries in the Outlook survey cite the lack of skilled staff as a major impediment to tax collection. The constraining factors encourage corruption, as highlighted in the country notes of Cameroon, Comoros, Guinea-Bissau and Nigeria.

The surveys have shown that despite great progress in adopting Information and Communication Technology to increase revenue collection, more can still be done. South Africa offers e-filing for payroll taxes, while Botswana, Cape Verde and Cameroon have e-taxation platforms. These initiatives require educational campaigns to motivate individuals and enterprises to use these systems. In Cape Verde, about 15% of companies used the new e-taxation system in 2009. Algeria, Angola, Côte d’Ivoire and other countries are looking for ways to incorporate new technology in their taxation systems.

Getting donors to help

Whether, overall, aid helps or hinders public resource mobilisation remains unclear. However, it is a well established fact that the share of aid aiming to strengthen it is still very small.

There is increasingly widespread concern that the availability of foreign aid may reduce incentives for governments to raise domestic revenue. This may, in turn, negatively affect the quality of governance by reducing pressure for state capacity development and reducing incentives for government to bargain with citizens over taxes, as discussed earlier. Obviously, tax administrations are genuine in their desire to raise revenue, but the availability of large foreign aid flows may reduce the urgency with which revenue collection is pursued. There is an additional risk that aid-dependent governments, in particular, will shy away from politically demanding income, property and local tax reforms, while these are precisely the areas that are likely to be most important to tax-governance linkages. In practice, however, it is very difficult to test the impact of aid on domestic revenue because of the many factors that shape tax collection. The debate amongst academics remains largely inconclusive (Box 2). Eventually, aid donors are an integral part of the political economy of public resource mobilisation, even more so as they increasingly propose financial and technical assistance to increase revenue collection.

Indeed, ODA often includes components designed to increase revenue collection, such as direct funding for tax reform; conditionality that requires increased or at least constant, domestic revenue generation; requirements for local matching funds for aid projects; and/or demands for increased social spending which, indirectly, generate pressure for greater revenue mobilization. Figure 18 shows that public sector financial management represented 2% of aid spent on technical cooperation in Africa in 2008. Given that tax administration is a subset of technical cooperation for public sector financial management, donors’ help in building African tax administrations is less than 2%. The Outlook country surveys confirm that there is a lot of room to increase aid in this area. Finally, the issue of whether aid-funded goods and services should be taxed by recipient governments is discussed in the next section.