54086 February 2010 investment climate IN PRACTICE business taxation no. 8 Tax Compliance Cost Surveys Using data to design targeted reforms Businesses--especially small ones--often face heavy costs in the Jacqueline Coolidge process of preparing, filing, and paying taxes in addition to the burden Jacqueline Coolidge (jcoolidge@ of tax payments. These compliance costs, added to fines, penalties, and worldbank.org) was Lead Invest- ment Policy Officer in the World the risks of onerous inspections and demands for bribes, often deter Bank Group from 2003 to 2008 business creation and growth in developing and transition countries. and worked on tax administration A tax compliance cost survey can provide useful information for reforms and removal of administra- tive barriers to investment from the design of reforms to reduce compliance costs and risks for small 1993 to 2008. She is an expert on businesses. This note highlights key findings of tax compliance cost compliance costs for businesses from taxes and regulations as well as surveys conducted in South Africa, the Republic of Yemen, Ukraine, on monitoring and evaluation of the and Peru that measured the burdens on business. These surveys helped impact of reforms to improve the in- vestment climate. She is currently a fine-tune the design of reforms to lower costs for businesses and consultant for the World Bank Group improve their competitiveness. and other organizations. This note and others in the series While the fiscal tax burden on business (that is, face compliance costs equivalent to a turnover of IN PRACTICE notes on business the amount of taxes actually paid) is an obvious tax of up to 8 percent, which seriously hurts taxation reform were developed as focus for potential reform, there is growing their competitiveness. Added to the burden of part of a joint program between recognition that the costs to comply are also a tax payments, compliance costs and related costs burden, especially for smaller businesses. Costs to and risks are often the strongest deterrent to new the United Kingdom's Department comply are measured both in financial terms (for business creation in many parts of the world. for International Development instance, how much it costs to hire professional (DFID) and the World Bank Group's tax preparers or buy software for e-filing) and Investment Climate Department as the opportunity cost of staff time spent in Why measure tax (CIC). The program focuses on preparing tax returns and related procedures. compliance costs? operational issues in tax reform, Since compliance costs within most tax regimes At the most basic level, if tax compliance costs particularly those related to micro- are relatively fixed, the burden is usually are high in a country, policymakers need to enterprises and small businesses. highly regressive--a relatively minor cost for know which taxes (profit tax, VAT, payroll taxes, The CIC business taxation product larger firms, but a very heavy burden for small or other taxes) and procedures (tax accounting, line helps governments implement businesses. For example, micro-enterprises in submission of tax returns, tax inspections) are effective tax systems to spur Ukraine that need to comply with profit tax, causing most of the burden for businesses and investment and economic growth. value-added tax (VAT), and payroll tax may should therefore be targeted for reform. Box 1: South Africa's New Tax Regime for Given the wide range of experiences, a tax Small Businesses compliance cost survey is often the best way to measure the costs and estimate the risks of The National Treasury of South Africa and the South Africa Revenue tax compliance in developing and transition countries. Several studies of tax compliance costs Service have initiated a number of reforms to small business taxation in have been carried out in OECD,1 and particularly order to improve efficiency, reduce unnecessary burdens, and improve anglophone, countries (Australia, Canada, New compliance.a While it is understood that micro-enterprises will not add Zealand, the United Kingdom, the United much revenue, the government is interested in creating a culture of States), which have documented the regressivity compliance and encouraging business growth, especially among previously of tax compliance costs. But until recently, only disadvantaged ethnic groups. a few small-scale studies had been conducted in developing countries (such as those in Croatia, India, and Malaysia). Both anecdotal evidence and previous studies had suggested that small businesses were reluctant to pay taxes and concerned about the time and The World Bank Group has recently completed some effort required to comply, the risk of making mistakes, and the penalties of the largest, most rigorous and comprehensive tax associated with such mistakes. compliance cost surveys to date in developing and transition countries. In addition to quantifying The National Treasury and the Revenue Service implemented a series of studies the costs and risks mentioned above, these types of surveys can measure (i) business capacity for tax to gather more detailed information about the problem in order to design a compliance (basic literacy and bookkeeping skills); new, optional simplified tax regime for small businesses. To account for the (ii) perceptions about the availability of reliable great diversity within South Africa, a set of surveys captured the costs of tax information on tax compliance; (iii) attitudes about compliance among small businesses, involving: (i) professional tax practitioners; compliance and evasion as well as the competence (ii) small and medium-sized business taxpayers; and (iii) informal firms. and fairness of tax authorities; and (iv) the relative The information gathered through the surveys reinforced an earlier Foreign advantages and disadvantages of different tax regimes in a particular country. Investment Advisory Service (FIAS) recommendation, based on an analysis of the marginal effective tax rates, to raise the mandatory VAT threshold and offer Governments can use data collected from tax a simpler tax regime for small and medium-sized businesses (SMEs). compliance cost surveys in multiple ways. Recent surveys of small businesses conducted in South The new regime, announced in the February 2009 Budget Address by the Africa, the Republic of Yemen, Ukraine, and Peru Minister of Finance, Trevor Manuel, raised the threshold for mandatory help illustrate how the results can be used for three main types of objectives: VAT registration from about $40,000 to $130,000. In addition, instead of paying corporate income tax based on profit, small businesses that opt To quantify specific compliance costs and for the new regime can pay a new turnover tax.b This regime is expected to pinpoint areas for reform; be roughly revenue neutral in terms of tax payments and revenue, but to To test premises and provide empirical significantly reduce the tax compliance burden for small businesses. support for reforms; To monitor and evaluate reform progress. Small businesses that use the new regime should find it much easier to Quantifying compliance costs and calculate their tax payments. In the past, many micro-enterprises struggled pinpointing areas for reform to fill out complicated tax forms and calculate taxable profits; the new In South Africa, the tax compliance cost surveys regime allows for a simple calculation based primarily on annual turnover. showed that small businesses outsourcing their The rate scale is progressive, and designed to ease and encourage graduation tax work paid an average of about $1,000 per into the regular tax regime for businesses that grow beyond the threshold. year to comply with four main taxes: corporate income tax, provisional tax, VAT, and employee a. The South Africa business taxation reform program was supported by the World taxes (see Box 1). This figure varied only slightly Bank Group and USAID. FIAS provided assistance in designing and supervising the among firms with turnover ranging from about three surveys and in developing three analytical notes based on the survey data. $20,000 to $2 million per year. The mandatory b. For details, see the South Africa Revenue Service web-site: http://www.sars.gov. VAT threshold of $40,000 in turnover per year za./home.asp?pid=43122. (in effect until 2009) could almost double the in PRaCtiCe bUsINEss TAxATIoN 2 compliance costs of small firms that grew enough Figure 1: Compliance Costs for Preparation of to cross the threshold (see Figure 1). Tax Returns in South Africa (Among sMEs that outsource tax compliance While tax compliance costs for some micro- to professionals, 2007) enterprises could be as high as 5 percent of turnover under the old system, the new simplified regime is 6 expected to keep compliance costs below 2 percent of turnover for most small businesses. This should 5 reduce the compliance burden and make tax returns percent of turnover Compliance cost as simple enough for more small business owners 4 to comply without outsourcing to expensive tax Firms registered for VAT preparers. For smaller firms that outsource their 3 tax preparation, the increase in the VAT threshold 2 alone would save them almost $500 per year in tax compliance costs; for those who undertook VAT 1 Firms not registered for VAT compliance in-house, it would save them roughly 45 to 70 hours per year. 0 20 40 90 470 1,335 Survey data can provide a high degree of detail Firm turnover (in $ thousands) to inform the design of specific business tax Note: X axis uses a modi ed scale to show the midpoints of rm segments based on reforms. In the case of the Republic of Yemen, turnover (converted to U.S. dollars from local currency). a key question is how to improve rates of Source: FIAS 2007. voluntary formalization and compliance, taking into account constraints such as literacy and As in most countries, tax compliance costs in South Africa were regressive, and therefore, ability to keep basic accounts. The business tax a heavier burden for smaller rms than for medium-sized and large rms. Before regime for nearly all businesses (except those 2009, the threshold for mandatory VAT registration was equivalent to about $40,000 officially designated "large taxpayers") has yet to in turnover per year. move to self-assessment, although literacy rates have improved significantly over the years. Until reforms are enacted, any business that declares it is not keeping full accounts is taxed presumptively, Box 2: Using the Survey Data in and the great majority of businesses have opted the Republic of Yemen for that system. In preparation for major reforms, the Yemeni government made a decision in The World Bank Group in the Republic of Yemen has been helping to design a principle to (i) exempt micro-enterprises from new small business tax regime. The tax compliance cost surveys in the Republic national-level taxation (but they may be subject to a small flat fee in lieu of regular income tax) of Yemen involved a representative sample of 950 businesses registered for tax in (ii) require all other firms to use self-assessment, the six largest governorates, and 860 informal businesses in the same areas. and (iii) create a new, "simplified turnover tax" regime for small businesses. In addition to providing data for the design of the new tax regime, it is expected that the information and analysis can be put to use in other ways. For example, Thus in the Republic of Yemen, survey data the data suggest that relatively more effort could be focused on large taxpayers, were used to correlate turnover with number of employees and determine current capacity for as the scale of evasion appears to be greater than that of medium-sized bookkeeping by size of firm (see Box 2). More than taxpayers. Although micro and small taxpayers also appear prone to evasion, the three quarters of "small" firms (and two thirds of revenue yield from enhanced enforcement among such firms may not be worth "micro" firms) indicated they keep at least minimal the resources required to enforce their compliance. books. Survey data also confirmed that a majority of owners or employees of small firms had completed The data can also be used in a public relations campaign, reminding informal secondary school and could be expected to meet filing requirements for a turnover tax. The survey firms of the costs and risks they face in the status quo and offering a comparison data were used to help define the parameters for of the benefits of formalization, which may help encourage at least some firms the new simplified tax regime for small businesses. to formalize. in PRaCtiCe bUsINEss TAxATIoN 3 Firms with annual turnover below the lower In Peru, where an optional simplified tax regime threshold might not have sufficient capacity to based on turnover has been available to many handle even a turnover tax (and would be subject small businesses for several years, the authorities to a flat, nominal "patent" tax), and those above an wondered why it was not more popular. A survey upper threshold could be expected to handle the of professional tax practitioners2 inquired about regular regime. the perceived advantages and disadvantages of the turnover tax versus the general tax regime. Survey If certain reforms are anticipated, then the responses suggested that the main reasons for lack questionnaire can be designed to collect the relevant of interest in the general tax regime were the upper data. For example, a survey can generate data that threshold and resulting constraints on growth (see shed light on the business owner's fundamental Figure 2). decisions: what legal form to choose; which sector; whether to grow larger or split a business Testing premises and providing into smaller pieces. Survey data can help correlate empirical support for reforms turnover, number of employees, and accounting Many countries do not have a consensus among capacity in determining the appropriate thresholds stakeholders (even within government) about the and other parameters associated with different tax need for particular reforms. Survey data can often instruments and regimes. help tilt the balance. For example, tax compliance Figure 2: The Simplified Regime versus the General Regime in Peru (among certified public accountants, 2009) The simplified regime The general regime Other reasons Other reasons Reasons not to le under the simpli ed regime Do not know about Allows to emit Reasons to le under the general regime this regime all invoices Requirements are too Lowest tax di cult to comply compliance cost Client's expectations to e only regime that grow above S/.500,000 allows client to grow Only regime for which Fixed assets >S/.126,000 client is eligible Easiest regime Net income >S/.500,000 to understand Does not allow for client's Did not advise economic activiy 0 10 20 30 40 50 0 10 20 30 40 50 Percent of respondents Percent of respondents Note: Soles/3 = US$1. Multiple selection was allowed for both parts of this question. Source: World Bank Group forthcoming. In the Peru survey, tax accountants were asked which reasons they give when advising clients (i) not to le under the simpli ed turnover tax regime, and (ii) to le under the general regime. Since the simpli ed regime was only allowed for businesses with annual turnover of S/500,000 (about $167,000), it is not intended for businesses that expect to grow beyond that size. in PRaCtiCe bUsINEss TAxATIoN 4 cost surveys were used to argue the case for reforms Figure 3: Estimated Profit Reported for Tax in the Republic of Yemen and Ukraine. Purposes in the Republic of Yemen (among business taxpayers, 2008) In most developing countries, tax authorities are keenly interested in the prevalence of evasion, particularly in order to more effectively target Respondent groups by turnover and size their risk-based audits. While data on the degree Micro 46 27 10 16 of tax evasion are always suspect, some surveys have queried business taxpayers about how much Small 53 30 4 12 income of "companies like yours" they believe is reported for tax purposes. This approach was used Medium 26 46 2 26 in the Republic of Yemen survey (see Figure 3). At the time of the Yemen survey, anecdotal evidence Large 53 17 13 16 suggested pervasive bribery in tax collection, yet substantiating data did not exist. The survey results Total 48 29 8 15 suggested that more than half (54 percent) of the surveyed informal firms escape detection; the rest 0 10 20 30 40 50 60 70 80 90 100 reported they had paid bribes to be left alone, Percent of respondents who believe most rms under-report pro ts (of a given percent) provided free goods or services to tax collectors, or had to relocate or temporarily close to avoid Estimated percent of pro ts reported detection (see Figure 4). Such information was a 25% or less 26ญ50% 51ญ75% 76ญ100% useful reminder that government officials may Source: FIAS 2008b. contribute to the problem of informality and that reforms could reduce opportunities for corruption. Survey respondents were asked: "Having in mind businesses similar to yours (in the same line of this business, same size, and same area), . . . what percentage of their In Ukraine, businesses were concerned about the taxable pro t would you estimate they usually report for tax purposes?" As shown in burden of tax inspections. While official data said the gure, 48 percent of total respondents said that businesses like their own report that barely 10 percent of businesses are inspected 25 percent or less of their pro ts for tax purposes. in any given year, anecdotal evidence suggested Figure 4: Costs to Avoid Tax Payments and Remain Informal in the Republic of Yemen (among informal businesses, 2008) 60 54% Percent of respondents 41% 40 20 9% 7% 5% 1% 0 None Pay bribes to Su er some other Provide free Temporarily shut down Relocate the government negative consequences products or the business to avoid business to avoid o cers to avoid caused by the fact that services to avoid being detected by being detected by tax compliance it is not tax compliant tax compliance Tax Authority Tax Authority Problems experienced by rms Source: FIAS 2008b. Survey respondents were asked: "Did your business experience any of the following problems [caused by the fact that it is not tax compliant]?" in PRaCtiCe bUsINEss TAxATIoN 5 inspections were much more common and the and evaluate the progress of reform. Ideally, a "panel" survey data confirmed the prevalence of visits from dataset captures responses from as many of the original tax officials (see Figure 5). After correcting the basis respondents as possible. However, in most countries, of the official data to remove inactive companies, the failure rate among many new businesses, especially state-owned enterprises, and non-profits, the official among smaller firms, limits this option. data were somewhat more similar to the survey data, but a significant gap remained. Further investigation Distinguishing the effect of tax and related revealed that tax officials often make "control" visits administrative reforms from overall economic to businesses for simple checks of cash registers, development and other trends is one of many which are not considered by the tax authority as difficulties in measuring the impact of such reforms.3 "official inspections." However, firms see these In the ideal setting, the survey can incorporate quasi- control visits as formal inspections in terms of their experimental design with "treatment" and "control" disruption of normal business activities. groups.4 However, even the most advanced, reform- minded governments in countries with highly In this area, the findings of the Ukraine and South trained and capable civil servants may have difficulty Africa surveys are in stark contrast. In South Africa, carving out matched treatment and control groups. less than 5 percent of SMEs are subject to any kind This is usually politically sensitive, but also may of tax inspection or audit in a given year. South not be legally, fiscally, or technically possible. For Africa uses risk-based audit selection to target its example, discriminatory treatment in policy is efforts on businesses most likely to evade significant unconstitutional in South Africa; any tax reform amounts of tax, a much more efficient approach must be uniform and country-wide. than subjecting most businesses to inspections on a regular basis. An option is to pair pilot regions for reforms a priori with similar regions, with selection of Monitoring and evaluation of reform progress regions based on a predetermined set of socio- The first round of tax compliance cost surveys economic characteristics. However, the scope for conducted in a country collects baseline data that such piloting may need to be confined to specific can be used to help design or fine-tune the reform administrative procedures. In South Africa, for agenda. Subsequent rounds may be used to monitor example, only relatively minor administrative reforms or outreach programs can be piloted. Given the sample sizes required for stable statistical Figure 5: Businesses Inspected by the Tax comparisons, a rigorous quasi-experimental design Authority in Ukraine and associated surveys to test the reform impacts (among legal entities, 2007) may not be cost-effective for such minor efforts. 80 A more feasible alternative is a very detailed baseline 70% 67% survey and follow-up surveys with oversampling of certain groups within the general population that Percent of respondents 60 48% will deliver enough data for both cross-sectional 38% and panel studies for future comparison. These 40 33% surveys should be combined with improvements in the collection, analysis, and presentation of 20 administrative tax statistics. 0 Under 37.5 37.5ญ125 125ญ625 625ญ4,375 Over 4,375 Lessons from tax compliance Respondent rm turnover ($ thousands) cost surveys Source: World Bank Group 2009a. The tax compliance cost surveys completed in Companies in Ukraine were asked: "Were there any inspections/audits (planned, several different regions have proven their value in unplanned, tax o ce documentary inspections/audits) at your enterprise conducted by the usefulness of their data. Survey data were used in the tax authorities, the pension fund and other social insurance funds in 2007?" South Africa to help design a new, optional turnover tax regime for SMEs and to decide on the new in PRaCtiCe bUsINEss TAxATIoN 6 threshold for mandatory VAT registration. In the Further details about tax compliance cost surveys IN PRACTICE Republic of Yemen, the data were used to determine are available in the World Bank Group publication, the parameters of the reformed tax regime, which Tax Compliance Cost Surveys: Guide for Practitioners The Investment Climate IN in turn was intended to encourage self-assessment (forthcoming, 2010). among small businesses. In Ukraine, the State Tax PRACTICE note series is published Committee expects to use the survey data to help by the Investment Climate inform and improve the system for risk-based audits. Endnotes Advisory Services of the World The Ministry of Finance in Peru plans to use the Bank Group. It discusses practical survey data to help improve the simplified regime 1 Organisation for Economic Co-operation considerations and approaches for small business so it is more conducive to growth. and Development. for implementing reforms that 2 In most cases, firms are legally required In addition to the basic survey reports, which to file tax returns completed by certified aim to improve the business present standard findings about tax compliance accountants. environment. The findings, costs by size of company, sector, geographic region, 3 This is particularly difficult for measuring interpretations, and conclusions and legal form, deeper statistical analysis can run changes in compliance versus evasion. See in included in this note are those of regressions and test hypotheses to provide answers particular OECD (2001). the author and do not necessarily to more subtle questions. For instance, governments 4 "Experimental design" requires randomized reflect the views of the Executive may want to know which informal businesses are assignment of subjects (usually individuals) most likely to formalize and how more can be to "treatment groups" (for example, those Directors of the World Bank or the encouraged to do so. Another question might target to receive a particular drug) and "control governments they represent. those firms outsourcing tax compliance work and groups" (those to receive a placebo). "Quasi- determine whether it is more cost-effective than experimental design" allows for non-random about the Investment doing the work in house. assignment, for instance, to matched jurisdictions (regions assigned to undertake Climate Advisory However, in order for the survey data to be reforms and similar regions assigned to accepted--whether in the design of tax reforms, maintain the status quo) in order to compare Services to overcome resistance to reform, or to be used the outcomes. for monitoring and evaluation--the quality of the The Investment Climate Advisory data must be particularly high in terms of statistical Services of the World Bank Group robustness. This requires scientific sampling and References helps governments implement large sample sizes. It also requires very well-designed reforms to improve their business questionnaires that are tailored to the specifics of Coolidge, Jacqueline, and Domagoj Ilic. 2009: "Tax the tax regimes in each surveyed country and that Compliance Perceptions and Formalization of Small environments and encourage and avoid any ambiguity in respondents' answers. Most Businesses in South Africa," Policy Research Working retain investment, thus fostering important, delivering solid data requires an extremely Paper No. 4992, World Bank, Washington, D.C. competitive markets, growth, and high level of quality control and supervision of the job creation. Funding is provided survey companies and data analysis. Coolidge, Jacqueline, Domagoj Ilic, and Gregory by the World Bank Group (IFC, Kisunko. 2009: "Small Businesses in South Africa: MIGA, and the World Bank) and Who Outsources Tax Compliance and Why?" Conclusion Policy Research Working Paper No. 4873, World over 15 donor partners working Bank, Washington, D.C. through the multidonor FIAS Tax compliance cost surveys in developing and platform. transition countries can be used to provide richer Foreign Investment Advisory Service (FIAS). 2007. detail about the tax compliance burden for South Africa ญ Tax Compliance Burden for Small businesses than might be available from standard Businesses: A Survey of Tax Practitioners. World Bank international benchmarks such as the indicators Group, Washington, D.C. http://www.fias.net/ measured by the Doing Business project. They ifcext/fias.nsf/Content/Pubs_BusinessTaxation can pinpoint a country's problem areas--both technical and geographic--for reform priorities, ญญญญญ. 2008a. South Africa Tax Compliance such as individual taxes and procedures as well as Costs: Provincial Analysis. World Bank Group, tax offices in specific regions. This information can Washington, D.C. http://www.fias.net/ifcext/fias. be extremely useful in designing appropriate tax nsf/Content/Pubs_BusinessTaxation reforms and monitoring their impact over time. (continued) in PRaCtiCe bUsINEss TAxATIoN 7 ญญญญญ. 2008b. "Yemen Tax Cost of Compliance Africa. http://www.fias.net/ifcext/fias.nsf/Content/ Survey." Internal report prepared for the government Pubs_BusinessTaxation of the Republic of Yemen. World Bank Group, Washington, D.C. World Bank Group. 2009a. The Costs of Tax Compliance in Ukraine. Investment Climate Advisory Services Organisation of Economic Co-operation and report prepared for the Ministry of Finance. Kyiv. Development (OECD). 2001. "Compliance http://www.ifc.org/ifcext/fias.nsf/Attachments Measurement ญ Practice Note." Tax Guidance Series ByTitle/PublicationCR_CostofTaxCompliance/ GAP004, Center for Tax Policy and Administration, $FILE/CostofTaxCompliance_Ukraine.pdf Paris. ญญญญญ. 2009b. 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