Unpacking Formalisation: The need for a new research agenda on taxation and the informal economy

Authors: Max Gallien & Vanessa van den Boogaard
Date:
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ICTD Informality and Taxation blog series

The ICTD’s Informality and Tax programme seeks to conduct, connect, and support novel research around the relationship between tax and informality. To introduce some of the central areas of research in this area and highlight relevant questions for policymakers and academics alike, we will accompany our work with a series of blogs on informality and taxation. This instalment focuses on attempts to draw the informal economy into the tax net.

According to the ILO’s latest estimates, almost 70% of the labour force in developing and emerging economies is in the informal economy. For Africa, the figure is 85%. Considering its sheer size, and the resulting loss in tax income that is often assumed to go along with it, governments across the developing world have long been interested in ‘formalisation’, i.e. policies aimed at drawing the informal sector into the tax net. ‘Formalisation’ is typically presented as an opportunity to access untapped revenue sources, to create conditions for dynamic growth in the informal economy, and to draw the economically marginalised into a new social contract with the state.

We are sceptical that the most common approaches to ‘formalisation’ are likely to consistently achieve their objectives. In reality, formalisation policies often move slowly, generate little revenue, produce unexpected results, face local resistance, and risk entrenching the marginalisation of targeted groups. New policy discussions around taxation and the informal economy are needed in order to develop more targeted and appropriate approaches to taxing small and informal firms.

More effective strategies will require better understanding of the complex relationships between governments, tax administrations and informal economies. In particular, research—and the policy that results—should be grounded in four key considerations:

  1. First, there is no simple distinction between formal firms and informal firms: there are many degrees of ‘formalisation’, with many firms registered in some areas, but not others, and paying some taxes and fees, but not others.
  2. Second, formalisation policies, including registering new taxpayers, are often drawn up without adequate appreciation of the practical challenges of taxing informal businesses and actually raising new revenue from registered taxpayers.
  3. Third, the term ‘informal sector’ lumps together a hugely diverse set of businesses, ranging from large tax-evading firms to small and micro businesses. Relatively large, but informal and cash-based firms present a major problem of tax evasion. By contrast, expanded taxation of smaller firms offers limited revenue potential, while requiring distinctive strategies more attuned to questions about equity, inclusion, and administrative realities.
  4. Finally, simply widening the tax net is insufficient to strengthen tax–accountability linkages or taxpayer engagement. More nuanced strategies are likely needed.

“Formalisation” does not mean any one thing

Economic informality has a variety of causes and dimensions: there is not one single place where businesses and states interact, not one universal tax that informal businesses fail to pay, not one unique service that they are excluded from. Legally speaking, a firm may be registered with the business registry, but not with the tax authority—or vice versa.  Neither form of registration guarantees compliance with tax laws. Formalisation has many components and they do not always go together. Conceptually, formalisation may also have multiple meanings: for a tax agency it may be a route to new revenue; for the business registry, an effort to improve regulation; and for firms themselves, an opportunity to access state services and new opportunities. When researchers or policymakers imagine that formalisation is a single thing, with a single meaning, we misrepresent a more complex reality in ways that can potentially lead to inappropriate policy choices.

Perhaps the most common strategy adopted to “formalise” the informal involves drives to register new taxpayers. The frequent presumption is that formal firms pay taxes and informal firms do not.  But in practice there is no simple binary between registered and unregistered businesses.  Businesses are subject to different taxes and payments, some of which are formal, some of which are informal, some of which require a registration, and some of which don’t. While the VAT and corporate income taxes generally require registration, many other payments do not—including market taxes, property taxes, local business licences, some presumptive taxes, other local fees, and potentially significant informal payments to state and non-state officials. Recent research—including in Ghana (found here and here), the DRC, and Sierra Leone—makes clear that while informal businesses may not pay all formally-mandated taxes, they are frequently paying some taxes and fees, alongside a range of informal payments.  Meanwhile, many formally registered firms do not, in fact, pay any tax at all. One implication is that expanded taxation of smaller informal firms may sometimes increase already high burdens of taxes and fees on lower-income groups, while distracting attention from non-compliance by larger formal and informal firms.

Registering taxpayers is not the same as raising revenue from taxpayers

Understanding formalisation as merely expanding tax registration risks bloating tax registers without really raising revenues. For example, the Taxpayer Register Expansion Programme in Uganda resulted in data inaccuracies and duplications, with, for example, 16,107 individual taxpayers recording the same national identification number; 6173 recording the same passport number; 3360 recording the same email address; and 1742 giving the same phone number. Meanwhile, recent research in Rwanda, Uganda, and Eswatini highlights the problem that taxpayers who are registered with the tax authority and file declarations may still report zero on all dimensions of their tax declarations, including income and tax. In 2017, about 56% and 23% of corporate and personal income tax declarations filed in Rwanda, respectively, were nil. The individuals and companies submitting these declarations contribute no revenue and report essentially no information to the revenue authority, despite being ‘formalised’.  There is an evident need for strategies that are consistent with administrative realities on the ground.

The informal economy is diverse

One of the driving motivations behind formalisation programmes across the globe has been the assumption that the informal economy holds large “untapped” revenue sources. However, this assumption is deeply misleading, with projected figures lumping into the aggregate a sector that is not only hugely diverse in terms of its current tax and registration status, but also in terms of its actors and business models. The informal economy includes small-scale street-vendors on one end and extremely wealthy tax-evading individuals on the other. To avoid comparing Apple Inc. to orange-vendors, so to say, formalisation strategies will inevitably need to be specific to the features of sub-sections of the informal economy.

In practice, formalisation strategies usually target small-scale taxpayers, traders, and street vendors. Generating additional tax revenue from small-scale informal economic actors, however, is costly. The additional revenue raised may do little more than pay the salaries of the tax collectors. More importantly, targeting small-scale taxpayers rather than larger non-compliant taxpayers—including self-employed professionals like lawyers and dentists— raises significant equity issues that are often left unaddressed. To avoid popular unrest and the further marginalisation of already vulnerable groups, equity issues need to stand at the centre of policy planning in this context.

Taxing the informal sector does not necessarily lead to positive taxpayer engagement with the state

It is often assumed that taxing the informal economy can provide the basis for a new engagement between citizens and authorities, promoting accountability and breaking what Judith Tendler called the ‘devil’s deal’, an equilibrium of mutual neglect where local politicians tolerate untaxed informal economic activity in order to secure their votes, but never develop an incentive to invest into developing and upgrading the clusters. However, supporting engagement between states and individuals in the informal economy not only requires that government agencies be willing to engage, but also that there are organisational structures and representatives within the informal economy with whom they can engage.

Organising within the informal economy, however, is often challenging: individuals in the informal economy often experience other forms of social and economic marginalisation and may be vulnerable to capture by more privileged networks or politicians. Simply widening the tax net does not imply that positive tax–accountability linkages will be formed – they are dependent on organisational structures within informal clusters, and how their interaction with state structures is organised. A better understanding of both is required for policy approaches towards the informal economy to lead to more positive taxpayer engagement with the state.

Taxing the informal economy: A research agenda

The widespread interest of policymakers in formalisation contrasts the extremely limited understanding, both among scholars and practitioners, of what formalisation means in practice and the conditions under which it might be equitable and progressive, rather than inefficient and risking exploitation and unrest. There is a need to better understand the local landscape of informal revenue generation in order to avoid adding new burdens on particularly vulnerable or already over-taxed groups, as well as the relationships of local authority and power that underpin them. There is likewise a need to better understand how different strategies to widen the tax net affect diverse segments of the informal economy and how policy strategies can be designed to be both more effective and equitable.

The world’s informal economies are enormous; many people who earn their livelihoods there are poor and vulnerable; formalisation strategies are diverse; and knowledge in this field is relatively scarce. It is for these reasons that we believe that novel research in this area, with a particular view to the equity and political implications, can make a substantive contribution to tax and development practice.

Interested in conducting research on unpacking formalisation or wider themes on informality and taxation? We are currently looking to support innovative research on these issues and are accepting project proposals on a rolling basis. See our call for proposals here.

Image credit: © Rhiannon McCluskey
Max Gallien
Max 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 recently 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.
Vanessa van den Boogaard
Vanessa is a Research Fellow at the ICTD and a Senior Research Associate at the Munk School of Global Affairs and Public Policy at the University of Toronto. She has submitted her PhD thesis on informal revenue generation and statebuilding in Sierra Leone and has ongoing research on the topic in the Democratic Republic of the Congo and Somalia. Vanessa leads the ICTD’s new programme on civil society engagement in tax reform and co-leads the research programme on informal taxation.