Design features of simplified tax regimes for small businesses in Sub-Saharan Africa

Sub-Saharan Africa (SSA) is estimated to host a quarter of the world’s small businesses; however, they typically contribute minimal tax revenue due to high informality and non-compliance. For example, in Kenya, out of approximately 1.5 million small businesses, less than 30,000 firms are registered with the revenue authority, and only around half of them file taxes regularly. As a result, small businesses only contributed less than one percent of total tax revenue in 2023.

Our new working paper highlights to the challenges of designing appropriate tax regimes for small businesses as governments face stark trade-offs between raising revenue, maximizing simplicity, and maintaining equity. Most SSA countries (31 out of 48 countries) have introduced a “Simplified Tax Regime” (STR), often referred to as a presumptive or turnover tax regime, to make it easier for small businesses to comply compared to more complex corporate or personal income tax regimes. Beyond simplifying the taxpaying process, STRs aim to collect a meaningful amount of revenue while also ensuring that the tax burden is distributed equitably among small businesses and across tax types.

Governments in the region have implemented STRs in various ways, resulting in sizable differences in how they balance revenue, simplicity, and equity considerations. To illustrate this, we produced a unique stock take of STRs in SSA, using the most recent tax legislation and policy guidance notes on business taxation in these countries.

Three stylized facts emerge from the stock take, which we discuss in the paper and summarize below:
 

1. Most countries do not apply a minimum turnover threshold.

Only 40 percent of SSA countries with an STR apply a minimum turnover threshold, which ensures the smallest businesses are exempt from paying any tax (see Figure 1). In the remaining countries, as soon as any business, no matter how small, makes any revenue, they are required to pay tax. Of the countries that apply a minimum threshold, the average threshold is $5,456, with countries such as Cameroon, Eswatini, and South Africa setting relatively high turnover thresholds (more than $15,000 a year), and others, such as the Central African Republic, Ghana, Malawi, Rwanda, Tanzania, and Uganda setting more modest turnover thresholds (between $1,500–$3,000 a year). Clearly, there is an important tradeoff as to whether and where policymakers set a minimum turnover threshold, as making smaller businesses exempt is a more vertically equitable approach. However, it comes at the cost of not raising as much revenue.
 

Figure 1: Spatial Distribution of Simplified Tax Regimes in Sub-Saharan Africa

2. Most countries rely on a percentage of turnover for determining the amount of tax owed.

Around 60 percent of SSA countries with a STR rely solely on a percent of turnover for determining the tax liability, whereas in the remaining countries, either a set fee or combination of both is used. Rwanda and Ethiopia, for example, apply a set fee until a certain turnover threshold, after which a percent of turnover applies. Uganda and Tanzania apply a set fee if no administrative records are maintained and a percent of turnover otherwise. Benin, the Central African Republic, Madagascar, and Mozambique apply a set fee or percent of turnover, whichever is higher. Setting the tax liability to a percentage of turnover ensures the smallest businesses are required to pay less tax, but this introduces an administrative burden as many small businesses do not maintain records and may not be able to determine their turnover accurately. A further complicating factor is that many countries have multiple, differentiated, or progressive STR rates. Hence, in some countries, STR rates set as a percentage of turnover may be more equitable, but they are less straightforward to comply with.
 

3. There is substantial variation in the size of tax obligations across countries.

The relative size of tax obligations levied on small businesses varies considerably from being relatively small to being a substantial burden that likely exceeds the effective tax rate under the Corporate Income Tax (CIT) regime. We examine the profit rate that businesses would need to make for their level of taxation to be equal under both the STR and CIT regimes, which we call the "break-even" profit rate. This break-even profit rate ranged from around two to twenty percent across countries (see Figure 2). Businesses that have higher rates of profitability than the break-even profit rate would pay relatively less tax under the STR, while businesses that have lower rates of profitability than the break-even profit rate would pay relatively more tax under the STR. For example, in Uganda, a small business with a profit rate of two percent or more would pay less tax under the STR, whereas in Cabo Verde, only small businesses with profits above 18 percent would pay less tax under the STR. This analysis shows how most countries either potentially forego revenue by setting STR rates so high that they may discourage small businesses from formalizing in the first place or by setting STR rates so low that they incentivize them to never graduate to the CIT regime. Either way, governments clearly face a balancing act to raise revenue in a way that maintains horizontal equity across tax regimes.

This analysis of the stock take of STRs in SSA shows a wide variety of design decisions made by policymakers across countries, with significant implications for tax equity, simplicity, and revenue collection. In our paper, we build on this overview of the region by drawing on administrative and survey data to thoroughly examine a specific STR.

This analysis shows most small businesses lack knowledge about design features, such as the existence of a minimum exemption threshold, but they react strongly to increases in tax rates by lowering their declared turnover. We also conduct an experiment that encourages taxpayers to pay customized set fees - a potential alternative design of an STR that aims to better balance the trade-offs facing policymakers. This showed that a simplified STR can increase revenue, but this reduced equity among taxpayers.

Ultimately, we conclude that given the significant trade-offs SSA governments face with taxing small businesses, there seems to be relatively limited value in focusing taxation efforts on them, even though they make up a sizable share of the economy.

To find out more about small business taxation in Sub-Saharan Africa please join this event tomorrow—Wednesday, September 25, 2024.