Designing/Reforming Presumptive Tax Systems

Designing/Reforming Presumptive Tax Systems Experience from other regions Michael Engelschalk and Jan Loeprick Investment Climate Advisory Services World Bank Group

By asking SMEs (TCCS, Informality surveys), we learned that: WBG surveys on barriers to, on tax compliance cost: • Firms are well aware of the benefits and disadvantages of operating (in-)formally • Tax (rates and admin) are seen as a key driver of informality • There are significant direct and indirect costs stemming from tax avoidance • Other dimensions of formality are important and linked to tax formality decision • Fees, licenses and other nuisance taxes are a non-negligible burden, especially for small firms • Many firms have tried and failed to formalize: Information can go a long way… → There is a significant potential for voluntary formalization!

What does this mean for Small Business Taxation? • What everybody agrees on: General guidelines for MSME tax design…: • For small firms, system has to be easy to comply with - minimal compliance costs • For the authorities, the system must not require excessive administration - • ideally based on taxpayer self-assessment and risk based verification by the tax-authority, ... • Tax system has to encourage growth of business (advantages to graduation) • Special regimes need to include safeguards against abuses • Need to distinguish firms which have a lot to gain from becoming formal from subsistence activities (SMEs? – Micro vs. Small vs. Medium)

What does this mean for Small Business Taxation (cont’d)? • But, it’s a balancing act…

1. Simplification of gen. regime 2. Special regimes - Simplification of tax forms, filing and payment process, alignment of payments - Reduced direct tax rates - VAT simplification for SMEs a. Presumptive tax to replace income tax (+VAT) b. Single (presumptive) tax replacing all other taxes 1. Turnover based 2. Indicator based 3. Combined turnover and indicator based tax Design options and key issues • What is “small”? No universal definition • How should the system be designed to avoid both over- and under-taxation of SMEs? • What kind of safeguards are required to avoid abuse of system by larger businesses? • How to align the SME regime with the standard tax regime? • System must be perceived as fair and transparent • How to provide incentives for keeping proper books and records?

Design principles cont’d: What could it look like?

Broader challenges and questions • Lack of information about the target population • Outreach remains as important, a new simpler system does not address information gaps • Is a simple presumptive system really sufficient to alter informal businesses cost-benefit calculation? • Building-in linkages between taxation, licensing and business registration fees • Linking costs and benefits of formalization — offering carrots • Integrating small firms into the reform process!, but who are the partners in the reform process?

Moving from theory to practice… How is it done in Europe, Africa and Latin America?

Taxonomy of presumptive systems in Europe

What does this diagram tell us? • Presumptive tax systems are not widely used in European countries as a tool to simplify MSE taxation • Compliance challenges and operation of presumptive regimes: is there a link? • Reliance on alternative ways to reduce MSE compliance costs (cash accounting, less frequent filing, high VAT threshold). • Or: full application of standard regime without any simplification: Ireland, Luxembourg

Is Europe a unique case? • The situation is substantially different in other regions: • 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; e.g. Chile) • Africa: primarily turnover based presumptive systems for MSEs below the VAT threshold

Issues behind such regional differences • There is no general justification for a presumptive tax regime in a country with high administrative efficiency and good bookkeeping capacity in the MSE community • There is no ideal presumptive regime. Coordination of presumptive with standard regime is difficult. • Presumptive regimes risk being inefficient (low revenue potential; risk of obstacle for business growth; risk of larger businesses hiding in the regime) • Everybody complains about presumptive regimes – who likes them?

Presumptive systems are popular – or not!Romania and Georgia • Romania: simple turnover based system: tax base is 3% of turnover. • Low revenue yield • Little migration from presumptive into standard regime • Minister of Finance intends to abolish special MSE tax treatment • Georgia: had a special presumptive system for MSEs. System was abolished in 2004. Now new system to be re-introduced • MSEs complain about same tax treatment irrespective of business size • Low revenue yield of MSE segment • Resistance to detailed record keeping for business expenses

Georgia: Abolishing special tax treatment hurts some • Georgia: Lessons learned • Need simple tax with broad coverage • Tax rate should be moderate • Request from businesses to reduce bookkeeping requirements should be accommodated • Design option: • Tax based on turnover • No distinction between different small business segments • Limited possibility to deduct expenses

Is the performance of turnover based systems disappointing? Lessons from Africa • Many African countries are working on the reform of turnover-based systems. • Kenya: 3% flat rate system. • But: Very low revenue yield. Expected increase in voluntary formalization not achieved.New system not yet decided. • Tanzania: progessive system from 1.1% to 3.3% of turnover with higher tax burden for businesses not keeping sufficient books and records. • But: Expected increase in number of businesses keeping cash books not achieved. Currently reviewing system.

Is the performance of turnover based systems disappointing? Lessons from Africa • South Africa: Move to a progressive presumptive tax

Move from very simple to simple – but where is the graduation of simple regimes? • Kosovo: Move from patent system to turnover system • Patent: Flat quota depending on business activity and location (e.g. in capital Prishtina 200 € for trade and service, 125 € for transport, 100 € for businesses without fixed premises and artisans) • Turnover system: 3% for trade and transport; 5% for service businesses. • Georgia: Some elements of individual expense deduction • Basic rate of 5% on turnover for all small businesses • Tax exemption of micro businesses • Possibility to deduct business expenses up to a maximum of 50% of declared turnover

How to refine a simple system: France and Austria • France: from „systeme forfait“ to „micro BIC“: • Forfait system aimed at being precise and fair: tax burden for each business determined individually • High administrative costs • Negotiations with taxpayers increase risk of corruption • Micro BIC is based on standard cost ratios • Tax base is gross income minus 71% deduction for trading businesses • Tax base is gross income minus 50% deduction for service businesses • Standard income tax rate applies • Result: France moved from system focusing on individual SME to standardized, but simple system

How to refine a simple system: France and Austria Austria: System with partial cost deduction • Tax base is gross income minus standard (lump-sum) deduction minus deduction of individual expenses • Standard deduction is 12% (6% for certain service businesses). Special standard deduction rates can be determined by the MoF • In addition the following expenses can be deducted: • Cost of commodities acquired in the standard course of business • Salaries paid • Austrian system is ideal example of limited simplification

Could Egypt become a model? • System based on two elements: • Turnover based tax for micro businesses: Tax base is 40% of turnover for trade and manufactoring, and 70% of turnover for services. • Cash flow tax for small businesses below VAT threshold. A model? Yes in principle, but... • Should micro businesses really record their turnover? • Is tax administration capacity (risk analysis) sufficient to control cash flow system? • Does system sufficiently reduce compliance costs?

What are the implications for Asia?

Designing/Reforming Presumptive Tax Systems