Taxing the informal sector could be a ‘flop’

In a country that has a large informal sector, like Namibia, businesses private losses due to increased taxation are likely to outweigh any public gains.

15 October 2021 | Economics

Levying a tax on a sector of the economy that is still developing is the fiscal equivalent of putting the cart before the horse. Kimber Brain, Economist: IJG

PHILLEPSU UUSIKU

Generally, the informal sector is considered difficult to tax as it is associated with high administration costs.

Research papers have shown that attempts to tax the informal economy typically results in limited revenue, where the cost of collections outweigh the revenue raised.

One of the reasons for this is that it is difficult to identify and measure the business activities of informal sector establishments and professionals, as they typically operate in cash. Cash transactions leave no bank records or do not allow for proper accounting record keeping. There is a need for specialist or skilled accounting officers and tax auditors to interrogate business accounts effectively. These professionals come at a great cost, amongst othering monitoring costs involved.

The Namibia Revenue Agency (NamRa), which has the mandate to collect tax on behalf of the government said the current laws does not exempt operators in the informal sector from paying tax.

The Agency’s spokesperson Tonateni Shidhudhu, however, failed to answer to questions as to how the agency defines an informal market in Namibia, in the context of taxation, and how the new and existing businesses will be monitored in order to meet their obligations.

Shidhudhu pointed out that the informal sector is part and parcel of the current tax regime and when their profit is above the threshold, they are expected to pay tax.

NamRA is working towards strengthening compliance to ensure that those whose income is above the threshold honour their tax obligations, he said.

EFFECTIVENESS

Market Watch caught up with two local analysts to comment on the impact taxation on the informal economy.

According Kimber Brain, economist at IJG, the effectiveness of a tax on the informal sector depends on the size of a country’s informal sector and how successfully said tax regime is enforced. In a country that has a large informal sector, like Namibia, businesses private losses due to increased taxation are likely to outweigh any public gains that stem from increased tax revenues.

A perfectly enforced tax on the informal sector, meaning every business pays tax, would cause an exodus of labour from the informal to the formal market. If the formal economy can absorb these workers that will result in a more efficient allocation of capital in the economy at-large and boost tax revenue.

But Namibia is a vast country with a well-developed informal sector and comparatively small formal sector, so perfectly implementing a new tax regime in the informal sector would be, at the very least, exceedingly difficult. An imperfectly enforced informal sector tax, the far more likely outcome, would instead discourage activity in the informal sector in turn reducing the number of firms and decrease employment, he pointed out.

MAXIMISING REVENUE

It is often understood that taxing the informal economy can lead to significant revenue gains and would make the tax system fair.

According to somonis Storm economist Theo Klein, proponents for taxing the informal sector argue that players in this sector are under-taxed and therefore the tax system is not fair, or these players are actively evading taxes which is a criminal offense. This argument has shown to over-estimate the income of the informal sector and under-estimates the taxes that the sector is already paying. Often small-scale informal sector businesses pay more in value added tax (VAT), levies and other indirect taxes than is generally assumed.

“Given the existing weak effectiveness in tax administration in Namibia, we doubt that appropriate systems and sufficient human resources are available to effectively identify all informal sector players and administer tax collection from them,” Klein said.

Brain adds that in order to increase tax revenue, it is more important for government to create an environment that leads to growth in the formal sector rather than to force taxes on informal businesses that do not have the capacity to pay them.

Broadening the tax base is best done after a prescribed level of economic development is realised, not before. Levying a tax on a sector of the economy that is still developing is the fiscal equivalent of putting the cart before the horse, Brain said.

SOCIAL WELFARE

Taxing the informal sector risks overburdening the most vulnerable in society. It can be argued that a great deal of informal sector players are small scale operators with relatively low incomes, who would in any event fall under the tax threshold. In the current economic turmoil that our country is in, taxing the informal sector would reinforce deeply embedded income inequalities, Klein pointed out.

In the scenario where a new tax levied on the informal sector, which is predominantly comprised of low-earning Namibians, asymmetrically decreases take-home wages and overall employment without resulting in increased in-kind government transfers and welfare payments, or improved service delivery then taxing the informal sector will increase inequality, IJG’s economist said.

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