The majority of the workers in lower income countries, and the majority of its enterprises, operate in what is broadly referred to as the ‘informal economy’. From the perspective of governments’ relationships with their populations at large, as well as an equity perspective, new attempts to tax informality can therefore have substantial implications. Recent years have seen a lot of new conversations around such reforms. It is consequently appropriate that this topic is picked up in the Zero Draft for the Outcome Document of the Fourth International Conference on Financing for Development that was released last week.

The current draft text reads:

“We encourage the broadening of the tax base and continuing efforts to integrate the informal sector into the formal economy in line with country circumstances, including through harnessing emerging technologies, such as digital public infrastructure, reducing the cost of compliance and appropriate incentives.”

There are multiple positive things to note about the draft text: it recognises the importance of country circumstances, notes the often substantial compliance costs faced by small operators, and the choice to use the terms “integrate … into the formal economy” leaves room for a comprehensive approach that goes beyond taxation.

However, the language of the current draft still leaves substantial room for misinterpretation, and for – perhaps unintentionally – doubling down on policies that recent years have shown to be both ineffective from a revenue perspective and highly regressive towards some of the world’s lowest income groups.

Common Approaches to Taxing Informal Economies

There are many challenges of operating informally: this can be a lack of access to formal finance, unsafe working conditions or limited service provision. An integration of informal economic operations into the formal economy has consequently been a demand from a wide variety of actors, from revenue authorities to labour unions to informal sector associations. The challenge however lies in the fact that there is no commonly accepted definition of what everyone means by integration into the formal economy.

From a public revenue perspective, it is clear that the dominant strategies to address large informal economies in the past decades have relied heavily on:

  1. simplified or presumptive tax regimes and
  2. mass registration exercises

However, research by a wide variety of organisations working in this space has documented that these methods have by and large been both ineffective and highly regressive.

The Problems with Common Approaches to Tax Informal Economies

From a revenue perspective, research has shown that simplified and presumptive taxes as well as mass registration exercises have been ineffective. For example, while the majority of African countries operate some forms of simplified tax regime, revenue from simplified tax regimes accounted for only 0.5% of domestic revenue on average in 2022. At the same time, the dispersion of many small operators raises substantial questions about the collection costs of these taxes.

The cost-effectiveness of mass registration exercises has similarly been doubtful: recent studies have shown that mass registration drives often bloat tax registries with poor quality data that revenue authorities cannot act upon, increasing the number of taxpayers filing nil returns rather than capturing more revenue.

On top of their limited revenue effectiveness, both methods also have been shown to have highly adverse equity effects – meaning that doubling down on them in order to raise further revenue risks disproportionately hitting lower income groups.

Presumptive and simplified tax regimes have been shown to be highly regressive, with a disproportionately high burden on the lowest income earners, and therefore often also on women. In Africa, 60% of countries using simplified tax regimes do not have a minimum threshold. Even when thresholds do exist, they are often low, not adjusted for inflation, or not applied properly. Consequently, many people below the poverty line end up paying what can be substantial rates.

At the same time, research has shown that efforts to expand the tax base via mass registration drives often disproportionately capture lower-income individuals and firms (like market vendors and street traders). This is because they are often more visible than higher income operators (like professionals or wholesalers), who are better able to hide their income, intimidate or negotiate with collectors.

Finally, the presumed wider benefits of formalisation – such as better access to loans or better working conditions, are often not forthcoming from more tax-focused approaches to formalisation.

A New Approach

In line of the above findings, work from a variety of organisations in this space has suggested rethinking common approaches to taxing informal economies. This has included cautioning against optimistic projections of how much revenue can be raised through taxing informal economies. Dominant new ideas have also included a larger focus on more effective targeting of higher–income operators, sub-sector-specific strategies, better coordination between relevant government institutions and better dialogue with informal sector operators.

Proposals for Revised Text

The language in the current Zero Draft does not explicitly call for the expansion of mass registration or presumptive taxation – its framing remains broad, allowing a variety of different interpretations of the policies implied by “integrate the informal sector into the formal economy in line with country circumstances”. References to compliance costs, digital public infrastructure and incentives may give room to new approaches here. However, especially in combination with the reference to “broadening the tax base”, the current framing risks being interpreted and used in practice as encouragement to double down on many of the ineffective and highly regressive policies in use at the moment. This risks shifting some of the costs of financing development onto the most economically vulnerable groups on the planet.

This can be revised through relatively minor changes in the text. We recommend three specific changes that will bring the text in line with current research findings and cutting-edge policy discussions in this area:

  • Qualify the mention of broadening the tax base with a reference to progressivity and undeclared income and wealth. This encourages a rethinking of how to address the issues around the revenue ineffectiveness and regressivity of common approaches currently used to tax informal economies.
  • Make reference to sub-sector specific strategies. This highlights that while country circumstances are important, as the current text notes, the contexts of specific sub-sectors, such as street-vending or home-based manufacturing, are even more important in effectively engaging with informal economies.
  • Make explicit reference to protect the lowest income informal workers: this ensures the text clearly distances itself from common tendencies to shift some of the costs of financing development onto operators below the poverty line under the framing of broadening the tax net or formalising the informal sector.

We consequently recommend the underlined additions to the draft text:

“We encourage the broadening of the tax base progressively, focusing on undeclared income and wealth. and Continuing efforts to integrate the informal sector into the formal economy in line with country circumstances, including through harnessing emerging technologies, such as digital public infrastructure, reducing the cost of compliance and appropriate incentives, should be developed in a targeted manner to be appropriate for different sub-sectors and protect the lowest income informal earners.”

Max Gallien

Max Gallien is a Research Fellow at the ICTD. His research specialises in the politics of informal and illegal economies, the political economy of the Middle East and North Africa and development politics. He completed his PhD at the London School of Economics. Max co-leads the informality and taxation programme with Vanessa, as well as the ICTD’s capacity building programme.