What’s in it for SMEs? Rethinking small business taxation
In November 2019, CDA published the first instalment of its new Economic Policy Paper Series: What’s in it for SMEs? Rethinking small business taxation. This insights post distills the paper’s main findings.
Joseph1 runs two private schools in central Kampala. He pays his taxes not because it’s the right thing to do, but because he is afraid of retribution. He believes the government is right to levy taxes, but should, in return, take an interest in the survival and health of his business. “The Uganda Revenue Authority is only interested in my money, not the success of my business. If I disappear one day, no one comes to check on what happened to my business or to see why I am struggling”, he told the CDA team. Joseph’s sentiments are not unusual. Small businesses in Uganda feel strongly that taxes are a punishment, that the authorities blindly pursue revenue collection without considering the detrimental impact this has on small business growth. What is more, the heavy tax burden suppresses the formalisation of the very businesses that would significantly contribute to increased tax revenues if they were able to grow.
Figure 1: Percentage of small businesses identifying the problem as their main obstacle
The first paper in CDA’s Economic Policy Paper Series (EPPS) takes a closer look at the impact of taxes on micro, small and medium businesses (MSMEs). This sector has a large, as yet untapped, potential to drive job-rich economic transformation in Uganda. These enterprises are typically capital-constrained, operate in highly competitive markets, deal predominantly in cash, and easily evade the authorities. They are also highly entrepreneurial, dynamic, and often the only option for the unemployed youth to earn some income. From this perspective, MSMEs are an opportunity. In this light, it is important to encourage and support them so they might formalise and grow into tax-compliant, profitable, job-creating businesses. The paper finds that a destructive cycle currently prevails between formality and tax compliance: non-compliance and poor financial records prevent small firms from accessing formal finance and government or large corporate contracts. Instead of growing upwards, entrepreneurs artificially remain small, growing sideways and splitting out businesses to perpetuate informality. MSME taxation in Uganda needs to shift away from short-term revenue generation towards creating an enabling growth environment.
Small businesses currently pay a complex array of charges: presumptive turnover tax, local service tax, registration fees, trading licences, PAYE contributions for employees, VAT on inputs, property rates, and excise duties, to name a few. According to the government, these all serve different functions and are payable to different authorities. Businesses see things differently: they see them all as taxes levied by the same state. Even the smallest businesses are not exempt from certain registration and trading fees. There is also a strong feeling that certain taxes are duplicative – taxing businesses on the same activity or tax base. Taxpayers routinely report being “squeezed”, obliged to pay up without receiving any services to support their businesses in return.
Figure 2: Small business tax schedule
Further, the presumptive regime, ostensibly introduced to simplify the tax obligations for small firms, does not achieve its aim of building a tax compliance culture. Informality remains high, tax morale low, and the cost of compliance, as well as the cost of collection for the Uganda Revenue Authority, is high. At the same time, the revenue potential from the MSME sector is negligible. Thus the argument for alleviating the tax burden and increasing administrative efficiency is compelling.
Figure 3: Trends in presumptive tax collection
The paper proposes a reform and research agenda to promote a small business tax system that maximises revenue generation in the medium- to long-term by fostering the growth and formalisation of MSMEs in the short-term. Beyond simplifying the tax structure and removing punitive double taxation, the government should better incentivise tax compliance and help small firms acquire the skills necessary to do so.
Improving compliance (and revenue outcomes) requires a holistic approach, recognising that MSMEs are more likely to be motivated by “carrots” than by “sticks”. MSMEs currently perceive many disadvantages and few advantages from compliance, particularly when this results in a significant reduction in profits relative to non-compliant competitors. There is a strong feeling that tax officials are more likely to harass than encourage those who are in the tax net, and a deep mistrust of the government’s ability to translate taxes into services.
Quotes from small business owners interviewed as part of the report
Finding the right “carrot” can be difficult, while existing tax education efforts are costly and largely ineffective. Many taxpayers complain that it is difficult to determine (and pay) one’s full tax liability and difficult to find help to do so: visiting a URA office or attending a URA workshop is seen as going “too close to the lion”. This calls for “client-centred” tax education redesign: government should identify the most effective method for delivering tax education to small firms, considering its content and delivery channel, and link tax education to tax compliance. Further increasing the direct benefits of tax compliance, rather than simply relying on the fear of punishment, could contribute to building trust between the state and small businesses. A promising potential “carrot” is linking tax compliance to the provision of free, or subsidised, business development services (BDS). Accessible, affordable, and skilled management training and BDS services for MSMEs are currently lacking. Indeed, such services are rarely commercially viable. However, lack of access to BDS is a binding constraint on MSME growth. Investment in expanding both “hard” skills like bookkeeping and “soft” skills affecting strategic and management capacities is therefore dearly needed. Providing BDS to tax-paying businesses could thus serve two key functions: giving firms an attractive benefit from compliance, while also providing a potential source of funding (allowing a tax credit against the final tax liability of businesses for any BDS fees paid, for instance).
Figure 4: Tipping the scale
The key message is for government to tilt the scale in favour of tax compliance, rather than tax avoidance. The solution is complex, requiring government to pull several levers simultaneously. Making the tax burden fairer and reducing compliance costs is one element, but without improving the perception of government and overall tax morale, as well as providing small firms with direct benefits to tax compliance, revenue growth is unlikely to be realised.
 Interviewee’s name has been changed to protect his privacy.
Adrienne is a development economist whose research interest concentrate on public and fiscal policy for low- and middle-income countries. She has recently completed a two-year Overseas Development Institute Fellowship in the Tax Policy Department at the Ministry of Finance, Planning and Economic Development in Uganda. During her fellowship, Adrienne was chiefly involved in developing and drafting Uganda’s Domestic Revenue Mobilisation Strategy, a medium-term tax reform strategy seeking to improve both tax policies and the administration thereof. Adrienne holds an MSc in Economics for Development from the University of Oxford and a BA in Politics, Philosophy and Economics from the University of Cape Town.