Can taxing informal economy generate meaningful revenue?

BY LEARNMORE NYAMUDZANGA

On May 5-6, 2021 the African Tax Administration Forum (Ataf), in collaboration with the African Union (AU) and African Development Bank (AfDB), held the 5th High-Level Tax Policy Dialogue under the theme Post-Covid Taxation: Policy and Administrative Strategies for Mobilising Enhanced Domestic Taxes in Africa.

Indeed, the Covid-19 pandemic had the major socio-economic impact that caused a lot of challenges for public revenue around the African continent and the world at large.

In such circumstances, policymakers will be seeking new sources of revenue, therefore there is a need to come up with tax policy and tax administrative strategies to raise revenue that can be used to recover from the pandemic and finance sustainable development.

For a long time, there has been a call to broaden the tax base or net and one of the propositions, if not in all the national budgets, is taxing the informal economy or sector. Zimbabwe’s economy is predominantly informal.

According to the NDS1 “the informal sector presents a significant potential source of revenue considering that it constitutes a significant share of national income. In order to tap into this potential, the Zimbabwe Revenue Authority (Zimra) is expected to establish a Specialised Unit to ensure that the sector’s contributions to fiscal revenues are commensurate with the level of economic activity”.

My question is: Do we not have such a sector already? Anyway, this is a discussion for another day.

According to the Zimbabwe Independent (March 26 to April 1, 2021 In-depth interview), to improve collections from the informal sector, Zimra acting commissioner-general Rameck Masaire indicated that Zimra had developed a compliance management framework, which among other issues, covers the following areas:

  • Educational workshops and publicity campaigns;
  •  Simplification of the tax system to reduce costs of compliance;
  • Detecting non-compliance and take proportionate actions;
  •  Encouraging voluntary compliance;
  •  Advisory visits, courtesy calls, processing of tax registration and making information easily accessible online;
  •  Engaging the business community through their associations in the informal sector through meetings, workshops, and other taxpayer education programmes, also using social media platforms;
  • Implementing the Comesa simplified trade regime (STR);
  •  Physical examination based on risk assessment; and
  •  Post clearance audits and segmentation of clients through the establishment of the medium and small clients to allow the rest of the Zimra offices to channel resources towards monitoring of the informal sector tax compliance.

While all these efforts are laudable, for how long have they been in place? Did they lead to an increase in compliance and tax revenue?

To what extent have they dealt with the informal sector?

Considering the cost incurred versus revenue collected, is it worth it? As indicated above, is it worth it to allow the rest of the Zimra offices to channel resources towards monitoring of the informal sector tax compliance?

It is important for the authority to make sure that their efforts are not based on wrong or misleading assumptions which are not substantiated by evidence.

The idea of taxing the informal sector is not new and most tax administrations find it attractive. Tax administrations have been seemingly obsessed with registering firms and taxpayers for years (Moore, 2020).

When I was doing my Master’s in Tax Policy and Tax Administration in Germany (2015-2017), the idea of taxing the informal economy was so appealing to me. I remember very well doing a case study or transfer project entitled The presumptive tax and the Informal Sector in Zimbabwe, which I will discuss in my future articles.

I was left puzzled after doing a module on tax and governance by professor Mick More, a political economist, who was the chief executive officer at the International Centre for Tax and Development (ICTD) and professorial fellow at the Institute of Development Studies (IDS) at University of Sussex, Brighton United Kingdom.

According to Monye and Abang (2020) in their paper Taxing the Informal Sector Nigeria’s Missing Goldmine — analysts and policymakers often assume that informal enterprises are untaxed, and that there are substantial revenue gains to be achieved.

This may not be true and it is well analysed by the recent policy brief on Taxing the Informal Economy is not a Silver Bullet for Financing Development or the Covid-19 Recovery by Mick More, Max Gallien, and Vanessa van den Boogaard (www.ictd.ac).

In their policy brief, they argued that “. . . More genuine enthusiasm around taxing the informal economy is often underpinned by a range of misleading assumptions about the benefits of getting informal workers and enterprises onto tax registers.

This includes the argument that targeting informal economic operators will increase overall tax morale and compliance, raise the productivity of informal businesses and lead to more accountable relationships between informal firms and governments. As practical experience and a range of recent scholarship have highlighted, however, many of these assumptions are not substantiated by evidence”, (Moore et al, 2021.)  Is this not the case in Zimbabwe?

According to the policy brief by these three experts, evidence has shown that efforts to tax the informal economy has resulted in the following:

  •  It does not raise much revenue — It generates (considerably) less revenue than expected, in part because collection costs are high and tax payment does not necessarily follow from taxpayer registration; and
  •  It is often not fair — it increases the extent of unfairness in the distribution of the tax burden — small informal sector operators already pay more in tax-like payments and fees than is generally assumed, while tax collectors often overestimate the income potential of small firms.

The links between taxation and accountability are not guaranteed — it fails to stimulate the accountability benefits often associated with taxation, because informal sector operators often find it particularly difficult to engage in collective political action in response to taxation.

Indeed, taxing the informal economy is not a silver bullet for financing development or the Covid-19 recovery.

Moore and his team concluded that taxing the informal economy neither guarantees substantial new revenue nor a fairer tax system.

Instead, it risks increasing the burden on some of the most vulnerable groups. In the middle of an economic crisis, this would serve to reinforce deeply embedded societal inequalities.

Building new fiscal relationships with individuals and businesses not previously registered with the tax authority may nevertheless be a desirable policy under some conditions — namely, when policies to tax the informal economy are better specified and targeted. Rather than broadly targeting the informal economy, or focusing attention on small-scale, low-revenue activities (Moore et al, 2021).

I strongly support their view that policies should focus on identifying: large-scale economic transactions made in cash, fake transactions in business accounts, and higher-income individuals that currently escape the tax net, including professionals such as lawyers and dentists.

Meanwhile, closer state interaction with smaller enterprises and informal production clusters may be particularly constructive and valuable in the aftermath of the Covid-19 pandemic — but this interaction should be seen in a developmental context, with a focus on investing, addressing vulnerabilities and building relationships with citizens, rather than solely extracting revenue from them (Moore et al, 2021).

Way forward

Instead of focusing on taxing the informal economy, which neither guarantees substantial new revenue nor a fairer tax system, they proposed better ways to finance development and the Covid-19 recovery. Zimra and MoFED must take note of these proposed ways which are as follows:

Taxing the wealthy through income, property and capital gains taxes, is an underused but potentially effective revenue generation strategy in most low-income countries. There is significant evidence that simply closing tax loopholes (for example, dealing with Illicit financial flows) and addressing dysfunctional tax losses through corporate exemptions can lead to a substantial increase in revenue for governments.

Taxing digital transactions offers a promising way to target tax avoidance by big technology platforms, while recognising that these platforms have benefited significantly from the increasing move to online interactions in the past year.

Increasing taxes to combat climate change maybe a promising way for governments to raise revenue, while the costs to more vulnerable households or businesses can be minimised through rebates or other supports

Nyamudzanga is an economist, tax consultant, ZES member, holder of a Master’s in Tax Administration and degree in economics. Email: lnyamudzanga@gmail.com. These weekly New Perspectives articles are co-ordinated by Lovemore Kadenge, immediate past president of ZES. — kadenge.zes@gmail.com or mobile +263 772 382 852.