MSME Tax Simplification - OECDBuilding-in linkages between taxation, licensing and business...

THE WORLD BANK World Bank Group

Multilateral Investment

Guarantee Agency

MSME Tax Simplification –

Can it Tackle Informality?

Rajul Awasthi

Global Tax Simplification Team

Investment Climate Department

World Bank Group

Bogota, Colombia



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Table of contents

1. Taxing MSMEs: Objectives and challenges

2. Policy options and administrative solutions



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Why focus on Small Business Taxation (SBT)?

Informality/ enterprise formalization and MSME growth

Diagnostic studies on formalization decisions → SBT as an

“entry point”

„A World View of Informality― (Schneider/Buehn/Montenegro 2010, p. 35)

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But it is not just about registering informal businesses…

4

All countries

OECD

South Asia

Middle East & North Africa

Sub-Saharan Africa

East Asia & Pacific

Latin America & Caribbean

54.39

36.24

36.26

40.78

62.17

63.78

73.63

% of Firms expressing that a Typical Firm Reports less than 100% of Sales for Tax Purposes

Source: WB Enterprise Surveys 2007-2012

11.3

10.4

12.3

17.2

9.2

2.1

9.5

3 3 3

1

4

12

3

0

5

10

15

20

All countries East Asia &

Pacific

Eastern Europe

& Central Asia

Latin America &

Caribbean

Middle East &

North Africa

South Asia Sub-Saharan

Africa

Perc

enta

ge o

f bus

ines

ses

cons

ider

ing

the

issu

e to

be

the

grea

test

obs

tacl

e fo

r the

ir bu

sine

ss o

pera

tion

and

grow

th

0

2

4

6

8

10

12

14

Rank among 15 offered obstacles

Practices Informal Sector as the biggest obstacle Rank among obstacles

% of Firms expressing that Practices of the Informal Sector are the Biggest Obstacle



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Tax compliance costs are particularly significant for MSEs

Source: Tax Compliance Cost Surveys, WBG Investment Climate Dept, Selected Countries 2007-1011

0

2

4

6

8

10

12

14

16

18

20

0 - 5 5 - 13 13 - 24 24 - 41 41 - 66 66 - 104 104 - 161 161 - 246 246 - 374 374 - 567 567 - 855 855 - 1287

1287 - 1936

1936 - 2909

2909 - 4369

4369 - 6558

6558 - 9843

Ta

x c

om

pli

an

ce

co

sts

as

% o

f Tu

rno

ve

r

Turnover (USD '000)

South Africa

Ukraine

Uzbekistan

Armenia

India (Bihar)

Kenya

Georgia



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When the “cost” of formalization is too high…

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Businesses stay out of the

formal economy and can

get a ―free-ride‖

However: more risks, fewer

opportunities (esp. access

to finance)

Serious limitations to

business growth…

Spurs vicious cycle of

―squeezing‖ the few compliers => ticket price↗

Government is not reaching

revenue potential



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The burden of administering small business?! Number of businesses in the small taxpayer category continues to grow,

highly dynamic segment

With increasing importance of service sector number of high income MSEs

on the rise

How to maximize efficiency in allocation of (scarce) resources?

Cost of administering small taxpayers might outweigh (short term)

revenues raised

But is MSME taxation just about revenue? – The Tax and Development

Agenda:

Creating a ―culture of taxation‖ and regularizing of the rule of law and

legitimacy of the state

Encourage taxpayers to hold government accountable

To promote MSME growth



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There are actual benefits of MSME tax compliance

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The risk of tax inspections, both formal and informal, is significantly

reduced: less likelihood of having to pay bribes to stay out of tax net

Gets rid of limitations to business growth…need to split firms and business

to stay below a threshold turnover, for example…

Greater opportunities to access formal (i.e., bank) finance

Opportunities to get government contracts – usually restricted to tax-

registered entities

In a VAT regime, small un-VAT-registered firms lose business opportunities

MSME taxation a good instrument to strengthen local government and

foster links between the local small business community and the local

government

In the medium/long run, higher tax revenues for the government



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2. Policy options and administrative solutions:

What does this mean for Small Business Taxation?

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2. What does this mean for Small Business Taxation?

The overall objective

is a SBT regime:

With minimal compliance

and administrative costs

Closely aligned to the

general tax regime

Ideally based on taxpayer

self-assessment and risk

based verification by the

tax-authority

But, it’s a balancing

act…

Simplicity of a blunt

turnover instrument vs.

fairness of simplifying

the general regime

Simplified instruments

are a second best

solution and come with

many trade-offs

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A quick summary of pros and cons of taxing MSMEs differently

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Why not?

Can be a disincentive to

growth

Better to address

distortions directly

Threshold effects:

Inverted U shape of

effective rates

Distortions can become

a source of corruption

Why?

SMEs role in fostering

innovation and growth

Compensating for Market

failures/ financing constraint

Fixed cost component of tax

compliance + Cost of

administering small

contributors

Simplicity can help close

avenues for corruption



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There are important regional differences

Region # Countries analyzed Countries operating

presumptive regimes

European Union 21 8

ECA region 19 16

The Americas 19 16

Africa 25 23

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Transition countries: presumptive systems, primarily based on

turnover, in almost all countries

Latin America: primarily turnover / gross income based regimes for

micro and small businesses (in some countries limited to micro

businesses)

Africa: primarily turnover based presumptive systems for MSEs

below the VAT threshold



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A wide range of tax treatment of MSMEs

From very simple patent taxes to full application of standard regime

From high VAT registration threshold to no threshold at all

From exemption of micro businesses from taxation to uniform treatment

of all MSEs.

From substituting income taxes only to covering social security

contributions (Brazil, Argentina, Uruguay)

Inclusion (Peru, Brazil) or exclusion (Argentina, Colombia) of small legal

entities from presumptive tax regimes?

But also on the administrative side:

From practically exempting most MSEs from tax audit (Korea,

Germany) to comprehensive audit coverage (some FSU countries)

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The basic building blocks of MSME tax reform

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MSME tax

reform

Taxpayer

outreach and

communications

Tax

administration

training

Segmentation

of taxpayers

Designing

simplified tax

regimes

Implementing

rules and

regulations

Monitoring

implementation

MSME

compliance

management



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The devil is in the detail: SBT regime design options and challenges

What is “small”? No universal definition

How should the system be designed to avoid both over- and under-taxation of MSMEs?

What kind of safeguards are required to avoid abuse of system by larger businesses?

How to align the MSME regime with the standard tax regime?

System must be perceived as fair and transparent

How to provide incentives for keeping proper books and records?

What assistance to MSMEs is required to facilitate voluntary compliance with the regime?

How to reduce the administrative burden for the tax administration?

b. Single

(presumptive) tax

replacing all other

taxes

a. Presumptive tax

to replace income

tax (+VAT)

- Simplification of tax forms, filing and

payment process, alignment of payments

- Reduced direct tax rates

- VAT simplification for SMEs

2. Special regimes 1. Simplification of gen. regime

3. Combined

turnover and

indicator

based tax

2. Indicator

based

1. Turnover

based



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A whole range of issues/approaches: Examples

Georgia

Bold reforms but high compliance burden and little compliance among micro and small businesses

Kyrgyz Republic, Kazakhstan:

Misaligned thresholds; downward migration, widespread abuse

Yemen

Record keeping based on taxpayer capacity. Tax payments for almost all taxpayers outside the LTO negotiated

Sierra Leone

One size fits all? ► inappropriate tax treatment + accounting requirements; Administration squeezing the wrong end

Lao PDR

No official records, skewed audit focus; win-win for

admin and tp

Vietnam

A hugely complex “simplified” system



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Strengthening MSME regimes: Our work to support reforms

Evaluating/strengthening policy options - Learning from (regional)

success stories and mistakes

Disaggregation SMEs and setting adequate thresholds between micro, small, medium, VAT

Determining profit margins and setting appropriate rates

Building-in linkages between taxation, licensing and business registration fees; Linking costs and benefits of formalization —offering carrots

Integrating small businesses into the reform process!

―Smart‖ enforcement and outreach - Supporting the establishment of

dedicated administrative approaches/structures for MSME taxation

Specialized MSME service and information program supporting self-

assessment of SME tax

Risk based MSME audit programs (designing fallback indicators, focus

on outliers)

Technology – potential and limitations 17



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Main Lessons Learned

Ministries of Finance generally are pushing MSME tax reforms much

more than tax administrations. But tax administration management

needs to be involved early in the reform process.

System abuse by larger businesses is major problem in many client

countries. Need policy and administrative countermeasures.

Lack of reliable data considerably complicates fallback indicator design.

More research and analysis early in the system design process

necessary.

Refining good practice examples is required: not only how have other

countries done it, but also why have they done it in a particular way.

Refining approach to estimating turnover based on indicators and profit

margins based on turnover

Developing guidelines for MSME tax accounting design

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Some examples

South Africa

Bihar

Georgia

Kyrgyz Republic

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VAT is a Main Element of High Compliance Costs in South Africa

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Compliance costs as % of turnover for small businesses in

South Africa

Source: FIAS, Tax Compliance Burden for Small Businesses: A Survey of Tax

Practitioners in South Africa, 2007

0

1

2

3

4

5

6

0.15 0.3 0.65 3.5 10

Mid-point of turnover band (in R million)

Not VAT registered

VAT registered



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Bihar, India: Compliance cost burden is much higher for MSMEs

VAT cost as a percentage of turnover; Base- 1003

3.5%

0.8%

0.2%

Small sized

businesses

Medium sized

businesses

Large sized

businesses(Base; 621) (Base; 250) (Base; 124)

Cost of compliance, as a percentage of turnover significantly higher

for small businesses

1%

2%

3%

4%



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The small taxpayers contribute less than 1%

81% of the dealers have turnover below Rs. 50 lakh, and contribute just

0.87 per cent of VAT collected (2007-08 data)

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TurnoverNo. of

dealers

% of total

dealers

Tax

deposited

(Rs.crore)

% of total

tax

below 50 lakh 35058 81 30 0.87

50 lakh- 1 crore 2932 7 21 0.61

1-2 crore 2161 5 34 1.00

2-5 crore 1412 3 60 1.78

5-10 crore 555 1 59 1.73

above 10 crore 1009 2 3191 94.01

Total 43127 100 3394 100

Note that VAT payment of Rs. 62,500 implies a turnover of Rs. 50 lakh (applicable rate

12.5%, gross margin 10%)



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Simplified regime for small taxpayers

Recommended lump-sum, flat tax payment:

Single slab of small taxpayers, defined as those with turnovers below Rs. 4 million

Lump sum tax payment – Rs. 10,000 per annum

Payment in one or two installments at the option of the taxpayer

No input tax credit allowed

Optional scheme

Implemented April 2011 (start of fiscal year)

Result: As of March 2012, 4580 new taxpayers registered and paid the due tax

*Assumptions: Margin 8%; tax rate from 4% - 12.5%



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MSMEs in Georgia: 1st Reforms missed 80% of Georgian entrepreneurs

Significant improvements in 2005, but not for small firms

11%

17%

26%

16%

20%

8%

4%

15%

0%

5%

10%

15%

20%

25%

30%

small medium large total

Share of Firms Who Rated Tax Administration as a Major Obstacle to Their Businesses

Georgia 2005

Georgia 2008

(Source: Enterprise Survey 2008)

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Guarantee Agency

Smaller Firms Pay Larger Portion of Their Revenues in Compliance Costs

12.2%

4.5%

2.1% 2.6%

2.3%

8.2%

0%

2%

4%

6%

8%

10%

12%

14%

0-30K 30K-60K 60K-100K 100K-200K 200K-500K Overall Average

To

t C

om

pl C

ost

as %

of

Rev

en

ue

Annual Tax Compliance Costs as Percent of Gross Annual Revenue, Average by Revenue Group

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New taxation regimes

Micro Business - Turnover below 30,000 GEL

- Physical persons only

- No hired labor

- Certain activities excluded

- separate income derived from

each activity

Tax exempt

Small Business - Turnover between 30,000

and 100,000 GEL

- Physical person only

- No VAT registration

- Certain activities excluded

Turnover based presumptive

tax

3% rate if documented

expenses (excluding salaries)

equal to at least 60% of gross

income

5% in other cases

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Challenges

Encourage micro businesses to voluntarily register

Ensure proper turnover reporting of small businesses

Develop proper risk analysis system to detect major

underreporting by small businesses

Introduce fallback system for small businesses not keeping

any books and records

Develop very simple system for identification of micro

businesses which should move to the small business

category.

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Risk based audit selection for MSMEs – Example from the Kyrgyz Republic

Audit selection in the Kyrgyz Republic:

Discretionary decision making at local offices as a source of rent-seeking

Low capacity within Tax authority (IT and audit departments)

Limited data available and few tax offices connected to central server

Project developed risk criteria (and weights/scores) based on available

information and software for administration of audit process.

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66%

59%

10%

0%

10%

20%

30%

40%

50%

60%

70%

IEs SMCs Farmers

Reported audit coverage in the Kyrgyz Republic

Share of enterprises that were inspected by the tax committee in 2008

36%

32%

26% 26%

18%

1% 0% 0%

5%

10%

15%

20%

25%

30%

35%

40%

% of firms reported that informal payments are requested during tax inspections

Source: Enterprise Surveys: 2007-2010

Source: IFC SME

Survey 2008



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RBA software provides web-based access to local tax offices through the STS web site

Main functions

Segment and sector based analysis of taxpayer risks

Generation of audit plan based on risk assessment (HQ)

Internal administration of audits Audit notice

Monitoring of audits

Depository of audit materials

Quality control and monitoring of staff

Fewer, more targeted and transparent audits



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Thank you for your attention!

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MSME Tax Simplification - OECDBuilding-in linkages between taxation, licensing and business...

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