Formalisation can encourage business growth, create a better business environment, and help build a culture of tax compliance (Joshi, Prichard & Heady, 2014). An economic modelling study suggests that full enforcement of taxation on the informal sector would increase labour productivity and output through reducing economic distortions (Leal Ordóñez, 2014). However, it is unlikely that taxing the informal sector through formalisation of all firms would bring in significant tax revenues at least in the short- and medium-term (de Mel, McKenzie & Woodruff, 2013; Bruhn & McKenzie, 2014; Joshi et al., 2014). In general, a firm’s decision about whether to formalise is based on an analysis of the costs (which can include higher taxes) and benefits (such as growing the business through official advertising and access to credit markets) (de Mel et al., 2013). For some firms, especially small firms and micro-enterprises, formalisation would not be beneficial (McKenzie & Sakho, 2010), even if it were cheap and straightforward. Simplifying and lowering the cost of registration has little or no effect on getting small firms to formalise, according to a review of econometric evidence (Bruhn & McKenzie, 2014).
To tax firms while they remain informal, the guidance literature, based on econometric analyses and literature reviews, suggests taxing the goods and services that they buy and sell (through sales or value-added taxes) or through ‘presumptive’ or withholding taxes (Joshi et al., 2014). Another approach is to delegate the role of collecting tax to trade unions, and to business or other associations (Joshi & Ayee, 2008). Tax administrations may need to reorganise, as the informal sector can be difficult to reach through large bureaucracies (Joshi & Ayee, 2008).
Key reading
Joshi, A., Prichard, W., & Heady, C. (2014). Taxing the Informal Economy: The Current State of Knowledge and Agendas for Future Research. The Journal of Development Studies. Advance online publication.
This literature review provides an overview of the benefits and challenges of informal sector taxation through formalisation, taxing goods and services, withholding taxes and presumptive taxes. A ‘growing body of research’ suggests that formalisation of firms, which allows them to be taxed, may have ‘significant benefits for growth, or, at the very least, may not hinder growth’ (p. 5). Formalisation can enable access to credit, offer opportunities to engage with larger firms and the government, reduce harassment by police and government officials, and improve access to training and support programmes. Taxing the goods and services informal sector firms trade, for example through import and export taxes, may undermine country comparative advantage but would not impose compliance costs on informal sector firms. Neither would there be difficulties imposed by limited education on tax matters and limited capacity to deal with tax issues. While some countries gain significant revenue from withholding taxes, these can be administratively burdensome, create incoherence in the tax system and discourage tax reform. A presumptive tax regime can mean firms pay substantially lower tax rates than under the standard regime. This can reduce revenue and discourage firms from moving onto the standard regime.
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Joshi, A. & Ayee, J. (2008). Associational taxation: a pathway into the informal sector? In Brautigam, D., Fjeldstad, O.-H. & Moore, M. (Eds) Taxation and State-Building in Developing Countries: Capacity and Consent. Cambridge: Cambridge University Press.
This literature review outlines the associational taxation approach – delegating tax collection to unions, business or other associations – and identifies ways to improve informal sector taxation. Using this approach depends on the type of tax, the extent of revenue pressure on the government, the degree and nature of associationalism within the informal sector, and the channels of interaction with state institutions. To improve compliance it may help to shift away from organising tax administrations by locality and type of tax (sales, property and income taxes), towards organisation by type of taxpayer (e.g. large, middle and small taxpayers). Compliance can also be improved by reducing rates or offering rewards to firms that maintain effective records.
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de Mel, S., McKenzie, D. & Woodruff, C. (2013). The Demand for, and Consequences of, Formalization among Informal Firms in Sri Lanka. American Economic Journal: Applied Economics, 5(2), 122-50.
This randomised controlled field trial in Sri Lanka looked at incentives for companies to register formally and the impacts of formalisation. The study found that providing informal firms with information about the registration process and reimbursement of direct costs did not increase registration. On the other hand, larger payments to informal firms in return for formalisation (equivalent to one-half to two months of profits) did lead to increased registration. The authors concluded that formalisation is attributable to rational cost-benefit calculations. Land ownership issues were the most common reason for not registering. Follow-up surveys found that the firms that formalised only showed modest profit increase (except for a few rapidly growing firms which profited more), but their owners had a more favourable attitude towards government as a result of formalisation.
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McKenzie, D. & Sakho, Y. (2010). Does it Pay Firms to Register for Taxes? The Impact of Formality on Firm Profitability. Journal of Development Economics, 91(1), 15-24.
Using a quantitative analysis, this paper estimates the impact of tax registration on firms in Bolivia, the country with the highest levels of informality in Latin America. The study finds that tax registration can increase mid-sized firms’ profits, but lowers profits for smaller and larger firms. The mechanism seems to be that registration allows firms to issue tax receipts, which attracts customers who can claim tax refunds. Very small microenterprises often benefit least from tax registration, as registration costs often outweigh potential profits.
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- Examples of presumptive taxes include fixed lump sums depending on the tax entity’s occupation or sector, a minimum tax based on the assumed minimum income level, or a lump-sum minimum plus a percentage of gross receipts. TJN-A. (2012). Taxation and the informal sector (Africa Tax Spotlight 3). Nairobi: Tax Justice Network Africa (TJN-A).
- Where ‘larger firms [are] required to withhold taxes on their transactions with small firms, which is then remitted to government and credited against the future tax liabilities of those small firms’. TJN-A. (2012). Taxation and the informal sector (Africa Tax Spotlight 3). Nairobi: Tax Justice Network Africa (TJN-A).
- Bruhn, M. & McKenzie, D. (2014). Entry regulation and the formalization of microenterprises in developing countries. World Bank Research Observer, 29(2), 186-201.
- Leal Ordóñez, J. C. (2014). Tax collection, the informal sector, and productivity. Review of Economic Dynamics, 17(2), 262-286
