ICTD Research In Brief 3
There is growing interest in taxing the informal economy in developing countries. This paper examines the case for giving it greater priority, and suggests that policymakers and researchers should focus less on technical design issues, and more on strategies to encourage compliance, and to increase political and institutional incentives for reform.
Why tax the informal sector?
There are good reasons for the relative neglect of informal sector taxation: it offers limited potential for short-term increases in revenue; collection costs can be very high; and there are concerns that targeting small and micro businesses could have negative social and economic impacts.
However, there could be indirect benefits including building a culture of tax compliance among SMEs; reducing a sense of unfairness and hence encouraging tax compliance by formal firms; and increasing economic growth of small firms through the benefits associated with formalisation, including better access to credit, markets and services. There could also potentially be broader governance gains if taxation encouraged effective collective action among informal sector operators, and more institutionalised channels for state society bargaining. While research evidence for many of these benefits is still very preliminary, there is at the very least a good case for improving existing practices for taxing the informal sector which are often both ineffective and prone to abuse.
Policy options
There is a good deal of research into different policy options for taxing the informal sector.
They include indirect taxation through taxes imposed higher up the value chain on goods and services that informal operators buy and sell; expanding the reach of existing formal sector taxes such as income tax and VAT; and widespread imposition of presumptive taxes (examples for Ethiopia, and Ghana) on small firms to get over high compliance and administrative costs. All of these have drawbacks in terms of revenue potential and /or broader development outcomes: indirect taxation has limited impact on long-term compliance, does not offer potential growth benefits of formalisation, and is unlikely to spur governance gains; direct taxation has high administrative and compliance costs for very small firms; and presumptive taxes can impose disproportionately heavy burdens on
small fi rms if poorly designed. Moreover most existing research is narrowly focused on the costs and benefits of compliance; to understand why progress in practice has been slow, and outcomes mixed, there is a need for more focus on a range of factors influencing the incentives and capacity of small fi rms to formalise and become tax compliant, and on the incentives of political leaders and tax administrators to pursue reform.
Implications for policymakers
In seeking more effective ways to tax the informal sector, future research and policy should focus less on reducing costs of compliance and more on strengthening incentives and collective action among different stakeholders, including:
- positive incentives for small firms to comply with taxation and pursue formalisation;
- making reform more politically feasible and attractive to political leaders;
- strategic institutional reform to strengthen incentives for effective implementation;
- initiatives by states and governments to promote collective action by informal sector firms and create institutionalised channels for engaging with them.
- increasing credibility of government and trust among SMEs and state authorities
