FORMALISATION STRATEGIES

&

TAX POLICY DESIGN

Bert Brys Senior Tax Economist Sarah Perret Tax Economist Centre for Tax Policy and Administration

LAC Fiscal Forum, COSTA RICA

16-17 June 2015

• Informality

– Why do agents operate in the informal economy?

– Why bringing agents in the reach of the tax system?

– A selection of other key lessons learned from the Informal Economy literature

• Tax Policy & Informality

– “Tax policy and tax design” requires a “Tax and Informality” strategy

– Key Tax & Informality policy lessons

• Tax, Informality and Skills

• Questions & issues for discussion

Introduction

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1. High and costly labour, product, environment, financial market and tax regulatory burden augmented by the (financial) tax and “non-tax” burden | level of governance “G”, enforcement “E” and/ or net benefits “net B” < minimum threshold:

stringency of rules and (administrative, accounting, legal, financial, statistical & information and/ or time-related) costs to comply in the formal economy, both for start-ups and agents who want to continue operating in the formal economy,

the tax and “non-tax” burden faced by formal agents net of the tax and “non-tax” payments made by agents in the informal sector

Conditional upon governance, enforcement and/ or net benefits < minimum threshold

Informality: a variety of reasons why agents

operate in the informal economy

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2. Lack of Financial and other Net Benefits of functioning in the formal sector (i.e. net of benefits realized by agents functioning (partly or fully) in the informal sector):

Low benefits of being formal including (perceptions about) poor quality of public and social services;

Strong eligibility criteria to benefit from public and social services;

Public services being available to informal workers as well;

Higher public utility rates for formal businesses;

Lack of access to resources including land and credit in formal versus informal sector;

Competitive pressures from businesses working in the informal sector

Informality: a variety of reasons why agents

operate in the informal economy

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3a. Poor Governance in the formal and/ or the informal sector:

low institutional quality; absence of rule of law; weak property rights in the formal and/ or informal sector; low level of democratic accountability, level of bribes that formal versus informal agents are called upon to pay; and

3b. Low Effective Enforcement in the formal and/ or informal sector:

poor effective enforcement of legitimate rights and entitlements; poor effective enforcement of regulation; poor information provision to agents; poor effective auditing, possibly strengthened by the lack of good quality administrative information and/ or information flows between administrations; low level of sanctions and fines when non-compliance is found

Informality: a variety of reasons why agents

operate in the informal economy

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4. Lack of trust in Governance institutions and their enforcement, high degree of corruption faced by formal versus informal sector, low level of democratic accountability

5. Absence of or imperfect “formal” markets: absence of – or a too rigid functioning of – formal markets for particular inputs, such as temporary work, or outputs; a poorly developed banking sector such that it is difficult to obtain credit for businesses in the formal and/ or informal sector | high and costly regulatory burden, strict Governance structures and their Enforcement > minimum threshold.

6. High Poverty: poverty as measured by low income, the absence of schooling, a high share of rural population, a high share of the agricultural sector in GDP, and other poverty measures

Informality: a variety of reasons why agents

operate in the informal economy

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1. Tax raise Revenue: a potential significant source of tax revenue:

– Although many informal agents have low income so would have to pay little tax; high tax collection costs for tax administration;

– But tax revenue will increase as formalized businesses grow; it is a matter of building tax compliance within all firms.

2. To strengthen Equity: sustain tax morale and tax compliance among formal agents. Formalisation may offer agents a measure of predictability and protection from arbitrarily state and related racketeering action;

But:

– Agents typically have low- income and taxation is potentially regressive = rationale for presumptive tax regimes!

– Efforts to tax the informal economy might increase the risk of relatively coercive or corrupt behaviour by tax officials: these concerns need to be tackled at source!

Informality: why bringing informal businesses and

individuals within the reach of the tax system?

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3. To improve Social Welfare:

– Informality may impose significant economic risks and create vulnerability (in case of unemployment, health problems, disability, maternity, old age, etc.).

– On average, informality leads to underinvestment in the human capital of current and future generations, leading to long-run economic and social exclusion.

4. To improve Efficiency:

– The informal sector generates a negative externality: informal activities use and congest public infrastructure without paying a contribution (free-riding).

– Informal businesses take market shares from formal companies such that the latter lack a sufficient scale of production to increase their productivity (but albeit limited evidence).

Informality: why bringing informal businesses and

individuals within the reach of the tax system?

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5. To stimulate Economic Growth: While informality helps firms avoid certain costs, it may also preclude access to certain opportunities, including greater access to and/ or cheaper credit, increased opportunities to engage with larger firms and government contracts, reduce harassment by police, and access to broader training and support programmes.

Some recent evidence provides nuanced evidence that formalisation is growth enhancing.

– The growth benefits of formalisation are positive but are heterogeneous across firm types. The smallest firms frequently benefit the least while mid-sized firms typically benefit the most.

– As informality can be explained, to some extent, as rational sorting of firms and workers based on inherent productivity characteristics, formalization per se may not address the fundamental determinants of productivity.

Informality: why bringing informal businesses and

individuals within the reach of the tax system?

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6. To strengthen good governance: there is some but limited evidence that firms that pay taxes engage with the state, thereby promoting legitimacy, good governance and political accountability.

There are 3 channels:

1. In order to increase tax compliance, the state may be more responsive and accountable to groups that pay taxes;

2. Agents that pay taxes are more likely to make demands for responsiveness and accountability;

3. Efforts to tax informal sector operators could catalyse collective action and political engagement by informal sector associations.

Informality: why bringing informal businesses and

individuals within the reach of the tax system?

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Exclusion versus exit requires different strategies.

The duality “formal>< informal” is misleading: a continuum of firm types exists, from the most informal (subsistence-type activities) to the most formal businesses.

• Depending upon the context, businesses often move along this continuum, some seeking formalisation other falling into informality as the cost-benefit calculations of being in one category or another change.

• Formal and informal economies are intrinsically linked.

• Challenging to reconcile (especially) longer-run costs of informality for society and agents with (especially) shorter-run benefits of informality for individuals and businesses.

• Governments should make the cost-benefit shift in favour of formality for as many business types as possible through broad, including tax, reforms!

Informality: a selection of other key lessons

learned from the Informal economy literature

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Tax Policy and Reform needs to be embedded in a country-specific “Informal Economy” Strategy

• The tax system and individual taxes can be designed such that they provide incentives to the informal sector to formalize and to prevent formal businesses to become informal = The standard discussion in the “tax and informality literature.

• However, the informal sector itself (its size, characteristics, etc.) has an impact on how countries have designed and can design/ reform their tax system (beyond the standard tax and informality strategies).

Tax Policy and Informality: Tax Policy and Reform

and country-specific “Informal economy” Strategies

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Tax Policy and Reform needs to be embedded in a country-specific “Informal Economy” Strategy

• As a result, text book tax policy recommendations not necessarily constitute good tax policy in the presence of a large informal economy!

• Also, in light of those constraints, country’s implemented tax policies not necessarily constitute good tax policy in the longer run and may prevent countries from entering a sustainable longer run growth path.

• First best: implement only those tax policies which constitute good tax policy in the longer run.

Tax Policy and Informality: Tax Policy and Reform

and country-specific “Informal economy” Strategies

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• Tax mix in developing countries typically include distortive trade taxes, because revenues from other taxes are not available. Because of a narrow tax base (low incomes, large informal economy, poor tax administration, unproductive businesses), countries typically have levied high direct tax rates paid by those agents that do operate in the formal economy.

• High direct tax rates and trade taxes have not contributed to improving the productivity of domestic businesses.

• Policy advice developing countries typically have received: abolish trade taxes.

• However, abolishing trade taxes may make domestic businesses vulnerable to imports.

Tax Policy and Informality : Lessons learned

from the “Tax and Development” literature

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• Revenue implications: governments may have to increase direct tax rates even more, thereby further distorting the economy!

• McNabb and LeMay-Boucher (2014) find empirically that shifting the tax mix away from trade taxes towards CIT and especially PIT will decrease economic growth!

• Also introducing tax incentives to attract FDI is expected not to be good policy if it put domestic businesses at a competitive disadvantage compared to newly attracted FDI.

• CONCLUSION: tax policy reform needs to be accompanied by strategies that strengthen the formal economy and the tax administration!

Tax Policy and Informality : Lessons learned

from the “Tax and Development” literature

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• Very distortive business income tax burden – need to make economy and FDI less dependent on natural resources.

• Introduction of relatively strict international tax rules.

• Distortive financial transaction taxes as tax revenue raiser.

• Need to raise more revenues

• Very large informal economy (up to 70%) – very high inequality – very high offshore tax evasion.

• Tax reform needs to be accompanied by reforms that strengthen the formal economy, the tax administration, the legal tax framework as well as reduce offshore tax evasion!

• Making such a reform happen is a major challenge

Tax Policy and Informality: lessons learned

from tax policy reform in Colombia

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• Belgium: introduction of electronic invoicing in bars and restaurants; very high tax burden on labour income – electronic invoicing (for VAT purposes) may force many businesses into bankruptcy. A comprehensive reform is required that strengthens tax compliance but lowers the tax burden on workers at the same time.

• Mexico: why do the formalization strategies/ incentives have an impact today while they did not work in the past? Answer: tax is only one of the drivers of the informality. A comprehensive approach is required to make working in the formal sector more attractive!

Tax Policy and Informality: lessons learned

from tax policy reform in OECD countries

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Oviedo (2009): “policy packages can comprise a series of carrots and sticks that need to be adapted to the nature of informality in the country. In some countries, regulatory reform might be more relevant, while in others it could be regulation enforcement, administrative reform or tax reform”.

Strengthening tax enforcement ONLY may not be growth- enhancing. Oviedo (2009): “strengthening enforcement will work best when the appropriate incentives to formalize are created, so that informal agents have a viable transition path from informality to formality”.

Efficient tax and informality strategies within a country might evolve over time!

Tax Policy and Informality: other key Tax and

Informality policy insights

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• Informality will, on average, lead to underinvestment in human capital and skills of current and future generations.

• Incentives to work, acquire skills, or refrain from socially undesirable behaviour are seriously constrained when there is no clear path out of social exclusion (IADB, 2008). Informal workers may have fewer incentives to invest in their own and their children’s education, creating an “informality trap”.

• Good foundation skills for all is key for inclusive formal economy growth.

• Duality of economies will increase inequality, which in itself might harm economic development and growth.

Tax, Informality and Skills

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• Do Participants agree that a “country informality assessment framework” needs to be developed?

• Do participants agree that “Tax and Informality” recommendations need to be embedded in such a broader Informality assessment?

Questions and Issues for Discussion

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Bert BRYS, Ph.D.

Senior Tax Economist

Head Country Tax Policy Team

Head Personal and Property Taxes Unit

Tax Policy and Statistics Division Centre for Tax Policy and Administration

2, rue André Pascal - 75775 Paris Cedex 16 Tel: +33 1 45 24 15 97 – Fax: +33 1 44 30 63 51

Bert.Brys@oecd.org || www.oecd.org/tax

For more information, please contact:

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