Do small taxpayers pose a problem for tax administration? Are larger taxpayer units (LTUs) a beneficial part of modern tax administration? Small businesses used to be seen as marginal to mainstream economic activity. This has changed recently and the ‘small’ sector, especially services, is now seen as the driving force of growing economies. This IMF paper looks at the phenomenon of the small tax payer and provides some short- and medium-term solutions for developing countries.
Many tax administrators have argued that tax evasion has gone down among small taxpayers when a single tax is introduced. However, the separation of large and small taxpayers leads to distortions in economic decision making for production and consumption, and goes against tax theory. Small taxpayers should be appropriately taxed because their potential tax contribution can be quite large. In some growing economies there has been a growth in the small and micro business sector and inadequate taxation of this sector has meant that their tax/GDP ratios have suffered. Not taxing the small taxpayers appropriately also creates a distortion in the growth of the smaller versus larger enterprise sector.
There is little economic basis for the concept of a single tax. A single tax tends to yield little revenue and is likely to be unsuccessful in reducing tax evasion. Key findings are that:
- Although this is the case, LTUs have become a practical device in securing tax revenue.
- In emerging markets small to medium taxpayers possess a significant revenue contribution potential as restructuring has meant a rapid growth in services through self-employed small entrepreneurs.
- Single tax collects less tax from small businesses than their potential, increases vertical and horizontal equity and leads to adverse resource allocation.
- In terms of the separation of the tax payer, the cut-off point is likely to have little economic significance. Small taxpayers almost never get audited and can fragment their businesses to avoid tax.
- Three factors lead to low VAT yields: a high VAT threshold, undercoverage of services and hiding by medium-sized enterprises under the threshold.
- Social security tax could impinge upon a small business if it was required to perform an administrative function for government through a withholding function, thereby raising compliance costs for small businesses.
Care needs to be taken that a focus on large taxpayers is extended to the others, including small taxpayers, and they should not be assigned a secondary role in the generation of revenue. The small tax payer would benefit from tax simplification, not a single tax. Key recommendations are that:
- Small taxpayers cannot be expected to pay tax on the basis of a complex tax structure and a simplified tax regime should be set up. However, a single tax covering income, VAT and social security should not be enacted.
- Small taxpayers should pay their appropriate revenue share while their compliance costs should be reduced. More resources should be put into the administration of small taxpayers.
- The tax administration should regularly report on: any increase in taxpayer registration below the threshold; the allocation of administration resources and the decrease in revenue loss as more taxpayers graduate above the threshold.
- A Minimum Alternative Tax-like arrangement based on a combination of gross assets and turnover, whichever yields a higher revenue, could be substituted for income tax.
- A VAT regime suitable for small businesses is one that puts them below a threshold and allows them to opt into the system.
- Small businesses should be allowed to transfer withheld tax after a prescribed period of time to compensate them indirectly for the free withholding and transfer service they provide for government.
