International Development CommitteeWritten evidence submitted by Dr Stuart Basten, Adviser, Parliamentary Office of Science and Technology

TAXATION AND THE INFORMAL SECTOR IN LEAST DEVELOPED COUNTRIES, WITH A FOCUS ON ZAMBIA

Executive Summary

The informal sector can be defined in many ways, but is usually defined as MSMEs (micro-, small- or medium-sized enterprise) who is outside of the taxation system of a given locality. The sector is generally characterised by low incomes; very small turnovers and firm size, lone or family work; poor working conditions lack of social protection and low productivity. As a result of growing population, squeezes on agriculture, rural-to-urban migration and the inability of the formal sector to keep pace, this sector is growing and, in many Least Developed Countries (LDCs), accounts for the vast majority of labour involvement. We provide new collated estimates of the informal sector for a series of LDCs.

Including the informal sector in the tax-base is a key strategy for many LDCs—not least Zambia, where the sector accounts for over 90% of total employment, yet with only highly marginal level of tax compliance. In our Zambian case study, we find that while a series of interventions have tried to widen the tax-base to include the informal sector, a number of barriers to success remain. These include compliance capacity, a poor understanding of tax process and/or benefits of paying tax, a negative view of the revenue collection authorities by many in informal sector and a possible lack of political will. We suggest that these can be tackled by continued taxation reforms based upon a better understanding of the informal sector; changing mindsets concerning tax by both demonstrating the benefits of formalisation and penalising tax-evaders of whatever size; increasing financial and human resources for both taxation audit and for the population at large and maintaining and building political will.

We also observe that informal sector in Zambia is not exclusively a residual sector with low productivity survival enterprises only, and that larger informal sector firms are run by entrepreneurs with higher education and greater access to infrastructure and banking facilities. These can be encouraged to prosper through increasing access to banking and lending services; improvements in infrastructure and education/skills development and enhancing business facilitation. Therefore, by encouraging these kinds of enterprises and increasing tax compliance, a double benefit of increased incomes per worker and increased revenues could be achieved. Indeed, the taxation potential from such successful sorts of enterprises is potentially highly significant. However, we conclude that the focus of such investments should not be entirely upon these larger MSMEs in order to ensure that the vast majority of the populous in small MSMEs are not “left behind.”

We conclude that simply including a company in the taxation system does not automatically render it “formal” in the sense that so many of the other features of “informal” work—as associated with “vulnerable employment”—including lack of social protection, risky working conditions, low job security, difficulty in accessing credit, reliance on family labour and so on. It is possible to argue that the strict differentiation between “formal” and “informal” is less useful than considering a “spectrum of formality” from the kerbside trader to the multinational business.

As such, including the informal sector in the tax system will bring these MSMEs one step closer to formality. However, investment in infrastructure, education and the implementation of the other measures discussed here would push these MSMEs further along the spectrum and, thus, increasing potential tax revenue both in Zambia and in other LDCs. In this view, the issue of taxation cannot—and should not—be separated out from the broader development and human capital agenda.

1. Introduction

While the inquiry of the Select Committee into Tax in Developing Countries has a focus upon larger scale tax evasion, it is important to recognise the potential impact of developing other, more “bottom-up”, tax-generating systems. A fundamental problem facing tax collection—and the subsequent implementation of welfare benefits and social security systems for workers—is the wide-scale engagement of labour in the “informal” sector. Developing the “formal” sector is an important development challenge—highlighted by the UNFPA at the LDC-IV Conference in Istanbul, 2011.

This briefing paper concentrates on Least Developed Countries (LDCs)1 and seeks to outline the current state of employment there, especially as linked to formal and informal economies, and how this relates to poverty alleviation. We then explore the relationship between formal and informal sector employment and taxation through an in-depth study of Zambia.

2. Formal and Informal Sectors in Least Developed Countries (LDCs)

2.1 Defining and measuring the informal sector

Measuring and defining the informal sector (as described below) is especially difficult concerning cross-country analyses, as different analysts have used the term “informal sector” to mean different things. Indeed, these differences have been exhaustively reviewed elsewhere (Jutting 2008; Jütting et al 2009; Turnham et al 1990; Maloney 2004). A recent survey, for example, found wide variations between country studies based on definitions of size, registration, conformity to fiscal and other regulations and degrees of modernisation. As such, it was concluded that the term “informal sector” may be appropriate for examination of individual countries, especially if the analyst defines it precisely; but its use in multi-country analysis is beset with difficulties (Mead and Morrisson 1996).

Box 1: Defining the Informal and Formal Sectors

Formal sector employment: Sector which encompasses all jobs with normal hours and regular wages, and are recognized as income sources on which income taxes must be paid.

Informal sector employment: “The 15th International Conference of Labour Statisticians (ICLS) defined the informal sector as units of production within unincorporated enterprises owned by households. Those employed in the informal economy comprise all persons who, during a given reference period, were employed in at least one production unit that meets these informal sector guidelines, irrespective of their status in employment and whether it was their main or secondary job. The ICLS resolution makes allowances for some national variations. As a result, information for the indicator is often based on national definitions and measurements of the informal economy” (Hussmans n d). However, as we shall see in our case study of Zambia, the “informal sector” can mean:

Anyone earning an income outside a formal job.

Businesses operating at subsistence level.

Businesses not registered with government authorities.

Businesses registerable in the light of their size, but deliberately avoid inclusion in the formal tax and levy systems.

Businesses where the predominant medium of exchange is cash.

Businesses with little or no accounting records.

Decent employment: Decent employment is an integrative concept that refers to both quality and quantity of labour. Decent employment should be productive and secure work, ensure respect of labour rights, provide an adequate income, offer social protection and include social dialogue, union freedom, collective bargaining and participation. Because many of these dimensions of decent employment are hard or impossible to measure or LDCs, the concept focused on in this report is productive and remunerative employment.

Vulnerable employment: Vulnerable employment is the proportion of own-account and contributing family workers in total employment. “Own-account workers and contributing family workers have a lower likelihood of having formal work arrangements, and are therefore more likely to lack elements associated with decent employment, such as adequate social security and a voice at work”

Despite the inherent difficulties in measuring the informal sector, either in the urban or rural setting, the evidence suggests that the size of the informal sector in most LDCs is large, and growing. The reasons for this are myriad, but include:

(a)Structural change in terms of population growth and limited opportunities in the agricultural sector has encouraged an unprecedented level of rural-urban migration. The inability of the public and private sector to meet the employment needs of this growing population—especially among the young—means that the informal, and often the urban informal sector, is frequently the only place to earn subsistence.

(b)Development policy in recent years has tended to support the informal sector either directly through microfinance projects, or indirectly through the structural adjustment programs which have seen a transfer of salaried staff into the informal sector (Spring 2009).

In the economic literature, these structural changes are represented by “dual-society” or “dual-dual society” models. An example is given in Figure 2.1. Recent change in LDCs, for example, has been characterised as a movement from top-right to increasingly bottom-right—compared, for example, to the European-historical and more-developed countries model of a general shift from right to left.

Figure 2.1

CHARACTERISATION OF A DUAL-DUAL SECTORAL MODEL

In Senegal, for example, a recent World Back study found that the informal sector accounted for 4.5 million out of a total nation workforce of 5 million (YEN and IYF 2009). A recent OECD report suggests that the informal sector employs 95% of workers in Benin and 90% in Cameroon, Ethiopia and Senegal (OECD 2008). In the South Pacific island countries, even though the informal sector is not readily visible, self-employment is increasingly the only alternative, given growing youth unemployment (ILO 2000). In Rwanda, 66% of the economy is informal and unmonetised (IMF/Rwanda 2008: 78), while in Mali the contribution of the informal sector to GDP is 39% (IMF/Mali 2008: 34). Estimates for 1999–2000 show that the informal economy contributed 43.4% to the GNP of African LDCs and roughly one-third to the GNP of Asian LDCs (Table 2.1). An important feature regarding the different scales of the economies of LDCs should be made here, however. Firstly, we are reminded that the informal economy GNP per capita is almost seven-times greater in Other Developing Countries than in LDCs. Secondly, the net worth of the informal economy in Bangladesh in 2000 ($166.9 billion) is equal to the sum of all of the African LDCs in the sample excluding Tanzania ($155.2 billion). As such, while the net worth of the informal economy in the three Asian LDCs in the sample are equal to the combined total of the 12 African LDCs, the population of the African LDCs is 29% greater.

Table 2.1

ESTIMATE OF CONTRIBUTION OF INFORMAL SECTOR TO GNP, 1999–2000

	Country	GNP at Market Prices, (current US$ billions) 2000	Informal Economy in % of GNP 1999–2000	Informal Economy (Current USD in billions) 2000	Informal Economy GNP per Capita (USD$2000)
Asian LDCs	Bangladesh	468.9	35.6	166.9	131.7
	Nepal	56.9	38.4	21.8	92.2
	Yemen	73.9	27.4	20.2	101.4
African LDCs	Benin	21.5	45.2	9.7	167.2
	Burkina Faso	21.7	38.4	8.3	80.6
	Ethiopia	63.3	40.3	25.5	40.3
	Madagascar	38.0	39.6	15.1	99.0
	Malawi	16.6	40.3	6.7	68.5
	Mali	22.6	41.0	9.3	98.4
	Mozambique	35.8	40.3	14.4	84.6
	Niger	18.1	41.9	7.6	75.4
	Senegal	42.9	43.2	18.5	211.7
	Tanzania	89.8	58.3	52.4	157.4
	Uganda	61.6	43.1	26.5	129.3
	Zambia	27.9	48.9	13.6	146.7

Source: (Schneider 2002) 6, 8, 11, 13, 16

2.2 A focus on the urban informal sector

A combination of slow agricultural development and high levels of rural-urban migration suggests the urban informal sector likely to be defined by large rates of growth over the next decades. This is reflected in numerous Poverty Reduction Strategy Papers (eg IMF/São Tomé & Príncipe 2005).

Table 2.2 demonstrates the strong reliance of the urban and non-agricultural labour market on the informal sector. Limited evidence suggests that this reliance is greater in LDCs than in Other Developing Countries (ODCs). Furthermore, women working in non-agricultural settings in both LDCs and ODCs appear to be more likely to be engaged in the informal sector than men. Indeed, in survey data from three African LDCs, women in non-agricultural employment appear to be almost exclusively engaged in the informal sector. However, yet again we are confronted with major issues regarding the availability of harmonised international data-sets.

Table 2.2

URBAN INFORMAL SECTOR EMPLOYMENT AS % OF TOTAL URBAN EMPLOYMENT AND NON-AGRICULTURAL EMPLOYMENT, LDCS AND ODCS

		Part A—Urban informal sector employment	Part B: Non-agricultural informal employment, 1994–2000
			% of total urban	% of total no-agricultural employment
		Latest year	employment	Women	Men	Combined
African LDCs	Benin	1999	46.0a	93	97	87
	Chad			74	95	60
	Guinea			72	87	66
	Ethiopia	2004	38.1a
	Madagascar	1995	57.5a
	Mali	1996	71.0a
	Tanzania	1995	67.0a
Available ODCs	Bolivia			63	74	55
	Brazil			60	67	55
	Cameroon	1993	57.3a
	Chile			36	44	31
	Colombia			38	44	34
	Costa Rica			44	48	42
	Dominican Republic			48	50	47
	El Salvador			57	69	46
	Ghana	1997	78.5a
	Guatemala			56	69	47
	Honduras			58	65	74
	India			83	86	83
	Indonesia			78	77	78
	Kenya			72	83	59
	Mexico	2000	19.4b	55	55	54
	Philippines			72	73	71
	Pakistan	1997	61.2b
	South Africa	1999	21.3 a	51	58	44
	Syria			42	35	43
	Thailand			51	54	49
	Venezuela			47	47	47

Sources:

Part A: ^a (World Bank 2010); ^b (ILO 2002);

Part B: (ILO 2002) [Informal employment in non-agricultural employment by sex, 1994–2000 [Data prepared by Jacques Charmes], p19

There are many reasons why working in the urban informal sector may be unsatisfactory. Working conditions are frequently very poor, with the most common issues being poor lighting, lack of ventilation, excessive heat, poor housekeeping, inadequate workspace, poor work tools and workplace design, awkward posture, exposure to dangerous chemicals, lack of clean water and other basic welfare facilities, and long working hours. Furthermore, no established mechanisms exist to monitor workplace injuries and illnesses in the informal sector, as they do in the formal sector. Injuries often go unreported and are settled by operators and workers, sometimes through small cash payments or termination of employment. Even for severe injuries, where they are not enrolled in a social protection scheme, workers are frequently deprived of benefits that would otherwise have been available.

“A shoeshine can make often 15 or 20 birr a day. This is good money but they will be insulted. If I have to do this I would have to go to a new city first.”

Ethiopian student (Mains 2007)

Stigma towards certain jobs—in some cultures more than others—also prevails, especially within the informal sector. In many East African settings, for example, artisan professions such as carpentry, blacksmithing, pottery and weaving (Freeman 2003) are often stigmatised, while similar observations have also been made for Senegal (Dilley 2004). (Although in other settings, such as among the Mande in Mali, blacksmiths are highly venerated (Perani and Smith 1998)). In urban Ethopia, so-called “lower work” including portering, waitering or shoe-shining is viewed as undesirable and potentially shameful not because of the hard work or low wages, but because of the status connected to these jobs and the reflection this would have on young men—who are constantly spoke to in the imperative, ignored, treated badly (Mains 2007). There is also a fear that this reflects on the broader families. This is known as yiluññta. One way of lessening yiluññta is to move from rural areas to the relative anonymity of the town (Mains 2007).

2.3 Informal economies, taxation, and the potential for change

Historical evidence strongly suggests that it is far easier to tax the formal sector than the informal which, by one core definition, is de facto outside the tax system. However, the evidence presented here suggests that in many LDCs, the direction of change (underpinned by ongoing structural developments) is in the direction of sustained high levels of employment in the informal sector.

Policy makers have sought to identify areas of potential expansion within the informal sector in an effort to begin to build a “connecting bridge between formal and informal economies” (Dan 2010). While some areas—such as individual street vending—do not lend themselves to expansion, others might. This can be achieved by identifying the branches of economic activity with demand potential, in which informal sector producers can either compete successfully with the modern sector or develop a complementary relationship with it. Growth and development of such enterprises can generate more employment and contribute, in the long term, to improving conditions in the informal sector as a whole (ILO 2000). In order to harness any sense of entrepreneurship—a recurring desire in PRSPs—investment in both physical and human capital will be required. The introduction of micro-credit schemes has frequently been met with success (eg IMF/São Tomé & Príncipe 2005), however interest can be prohibitively high creating another barrier to entry (IMF/Uganda 2010). Training, both on-the-job and the development of vocational and broader educational structures are also held to be key to this success. Indeed, as well as a general economic benefit, it is held that “prior learning and skills gained in the sector should be validated by certification systems which can help workers in the informal sector gain access to the formal labour market” (AEO 2008: n p).

Given the difficulties in defining the informal sector cross-nationally, it is exceptionally difficult to draw any international comparisons relating to the sector and potential taxation developments. In the next section, therefore, we will focus in on a case study of the informal sector in Zambia to examine in greater depth the relationship between the informal sector and taxation.

3. The Informal Sector in Zambia

3.1 The state of the informal sector in Zambia

According to the Zambian Government’s Sixth National Development Plan, the country’s labour force increased by 10% from 4.9 million in 2005 to 5.4 million in 2008, with total employment growing by 26.4% from 4.1 million in 2005 to 5.2 million in 2008. However, this growth was largely attributed to informal sector employment which grew by 47.6% to 4.7 million in 2008 from 3.1 million in 2005 (Republic of Zambia 2011). In other words, the informal sector accounts for 90% of employment in Zambia compared to just 10% in the formal sector. These workers are located in around 1 million MSMEs (Micro, Small and Medium Enterprises), of which the majority are either sole proprietors (35%) or family forms run by the owner with unpaid family members (32%) (Shah 2011). As such, it is no surprise that MSMEs in Zambia are characterised by very small sales levels (see Figure 3.1). 70% of these MSMEs are agriculture based, 21% retail, 3% manufacturing and 2% hotel and restaurant (Conway and Shah 2010).

Figure 3.1

DISTRIBUTION OF MSMES—BY MONTHLY REVENUES, 2010 [100K ZMK = 2.05GBP 2010 PRICES]

Informal sector MSMEs in Zambia are also characterised by:

Lower average per worker productivity, particularly in the urban context: those in microenterprises produce about 1/9 of the amount that workers in large enterprises do in the manufacturing sector and less than one-twelfth as much in the retail trade sector. As Conway and Shah (2010, p7) report, “unless the productivity of the workers in microenterprises can be increased, it will be difficult to increase the wages of their workers and the income of their owners”.

Lower labour costs.

Less access to infrastructure and finance, such as bank account, mobile phone, transport, water and electricity.

Owners who are less educated than in the formal sector.

Furthermore, the World Bank & IFC Enterprise Survey (2007) suggests that nearly three-quarters of service companies have to compete against unregistered or informal companies, while around a quarter of these companies identify the practices of competitors in the informal sector as a major constraint. Nearly 13% of companies identify corruption as a major business constraint.

Unemployment is also heavily concentrated in urban areas, further highlighting the precariousness of employment. Indeed in 2000, 73.7% of males and 90.8% of females were classified as being in “vulnerable employment” by the ILO.2

The Zambian government has set a target of decreasing informal employment to 50% of the male labour force by 2015 and increasing formal employment to 20% during the same period. Furthermore, however, there are national-level efforts to draw the informal sector into “the system”. For example, a core priority of the new Social Protection Policy is to empower Low Capacity Households through expanding social security coverage to both formal and informal sectors (Republic of Zambia, 175).

3.2 Taxation and the informal sector

One of the core objectives of Zambia’s Sixth National Development Programme is “To increase domestic revenue” (Republic of Zambia 2011)next section we will focus in on a case study of the informal sector in Zambia, and the prospects for future developments. The six ways in which it intends to do this are:

(a)Undertake tax policy and administrative reforms.

(b)Limit tax exemptions and incentives.

(c)Undertake a comprehensive audit and strengthening of all revenue points and revenue sources so as to enhance collections and yield.

(d)Explore alternative sources of financing such as Public Private Partnerships (PPPs), concessional and non-concessional loans for projects that have high economic returns.

(e)Explore other sources of revenue such as the informal sector and MSMEs.

Indeed, there is a “strong public demand” from persons in formal employment, unions, NGOs and Members of Parliament to broaden the tax base to include more MSMEs, not least in order to promote equity in taxation.

Currently, however, only 2% of firms in the informal MSME sector pay any type of income tax to the Small Taxpayer Office in Zambia, which has an annual turnover of less than 200m ZMK [£24k] (Mulenga 2011). The main tax for which MSMEs are liable in Zambia is the so-called “Turnover Tax” (see below). Based upon the annual revenue threshold of 12 million ZMK, it has been estimated that 99,000 farmers and 51,000 firms in other sectors—primarily retail—are eligible to pay Turnover taxes. Currently, only 9,029 Zambian firms are registered with the Zambia Revenue Authority to pay Turnover Tax, of which 8,173 are based in Lusaka. As such, most small firms are perceived to be de facto exempt because of the widespread non-compliance. Despite this, however, a large percentage of firms (up to 44%) report having to pay informal taxes and bribes.

Box 2: “Turnover Tax”

“Turnover Tax” is charged on gross sales/turnover (ie earnings, income, revenue, takings, yield and proceeds) which is below the 200m ZMK threshold. Any person carrying on any business with an annual turnover of 200m ZMK or less is liable to pay the tax with some exceptions (eg taxi/minibus drivers, certain partnerships, consultancies, other taxed incomes, companies voluntarily registered to pay VAT and persons involved in mining operations as provided under the Mines and Minerals Development Act.

The current rate of Turnover Tax is 3%. There is an obligation for taxpayers to keep all business records pertaining to turnover for a period of up to six years. (ZRA n d).

3.3 What has been done?

The Zambian Revenue Authority (ZRA) has instigated a number of reforms in an attempt to broaden the tax-based to encompass more MSMEs. Between 1995 and 2004, a conventional compliance approach revolving around compliance tax audits and other quantitative methods of estimating under-declaration was implemented. However, these measures did not adequately acknowledge the high rates of cash transactions with inadequate or incomplete records associated with the informal sector. Since 2004, however, a number of interventions have been developed by the ZRA to increase the tax-base and further compliance:

Increasing VAT coverage by invigilating randomly selected registered cash traders; introduction and auditing of cash registers; obtaining supply chain information of predominantly cash-based businesses; raising public awareness though the media on need to improve tax compliance (eg demanding an invoice on purchase); and the development of an Investigation Team to investigate and prosecute tax evaders.

New Presumptive Tax levied on all unincorporated passenger transport operations.

New Turnover Tax (see above and Box 2).

New Base Tax of 450 ZMK/day to be paid by those who do not keep books of accounts and operate as individual persons, especially marketers and small grocery shops.

Contracting third parties to collect Presumptive and Base Taxes.

Introduction of call centre facility easily accessible by taxpayers.

Furthermore, the Patents and Companies Registration Authority has begun to introduce mobile registration of businesses and is in the advanced stages of decentralisation of registration points throughout the country (IGC 2011).

3.4 What are the barriers?

There are, however, a number of perceived barriers to the Government being able to increase taxation coverage among informal MSMEs.

1.Compliance capacity: the majority of firms do not how to register for tax, or believe they do not have to be registered—usually in the belief that the business “does not make enough money”. Other reasons given for non-compliance include “unable to comply with requirements” and “It’s too complicated” (Shah 2011). Clearly, varying levels of literacy and the diversity of languages in Zambia—around 70 dialects—do not help the situation. (Mulenga 2011).

2.Poor understanding of tax process and/or benefits of paying tax: The Zambian Revenue Authority (ZRA) recognises that there is generally a poor understanding of the tax system. Furthermore, there is a low perception of the “benefits of paying tax” and increasing formalisation among MSMEs. This is compounded by a strongly negative view of “tax incentives” which appear to favour large businesses and multi-national investors.

3.Negative view of ZRA by many in informal sector: Participants at a recent International Growth Centre seminar observed that the ZRA should show greater value for the people’s taxes which, arguably, most in the informal sector simply do not see. This lack of re-investment inevitably creates the perception of the ZRA as a “tax police” which does not work with the people it taxes (IGC 2011). This will be discussed in greater depth in Section 3.5.3.

4.Lack of political will?: Given that 90% of the Zambian population are employed in the informal sector, the political capital necessary to broaden the tax-base would need to be highly significant. Furthermore, the ZRA recognises that the revenue potential over the short-term is likely to be “limited”, however full cost-benefit analyses of broadening the tax-base seem to be lacking (IGC 2011).

3.5 What else can be done?

The issues relating to the informal sector and taxation in Zambia need to be tackled in a variety of different ways which involve improving both the taxation system/culture and encouraging certain growth within the informal sector itself.

3.5.1 Continued taxation reforms

The ZRA admits that “much still needs to be done to improve the revenue uptakes in the [informal] sector” (Mulenga 2011). They suggest that the following needs to be done:

Better understanding of the informal sector: for tax intervention policies to be successful, they need to build upon the compliance challenges of the sector and take into account the lack of audit trails, infrastructure and, frequently, education. Furthermore, new innovations could be tested and implements. Indeed, a recent complaint was that certain past ZRA interventions were not based upon sound research (IGC 2011). One NGO, for example, has suggested the Government could explore the collection of taxes through the “associations” of informal workers as has been implemented in Ghana.

Changing mindsets concerning tax: improve the knowledge of the benefits of increasing the tax-base both for equitable and infrastructure development reasons. Similarly, prosecuting tax evasion is an important added deterrent. In this context, tax evasion by large firms and multi-national companies must be curbed in order to reduce the de facto rather blasé general attitude toward taxation. However, in order to change mindsets about taxation in the informal sector, a stronger demonstration of re-investment is needed (see Section 3.5.3).

Increase financial and human resources for both taxation audit and for population: The ZRA suggests that it requires further resources to increase its auditing and compliance building capacity. In 2008, for example, the “Small Taxpayer Office” responsible for the majority of MSMEs had only 155 members of staff. This could play an important role in expanding the geographical distribution of taxpayers in Zambia, which are currently heavily concentrated in Lusaka followed by the Copperbelt, Central, Southern and Lupala regions. Of all the registered firms in Zambia

Maintain/build political will: it is important that the Zambian government build upon their statement in the Sixth National Development Plan (Republic of Zambia 2010, p 15) to “undertake a comprehensive reform of the present tax system aimed at broadening the tax base and increasing revenue yield, while at the same time improving efficiency and equity” and maintain the momentum to meet the target of increasing tax yield from 15.7% of GDP in 2009 to 18% by the end of the plan period [2015]. In this context, there has been some recent criticism of the 2011 National Budget for being “mute” on the collection of taxes from the informal sector (Caritas 2012).

3.5.2 Encouraging larger scale MSME growth with tax compliance

In a recent presentation to The International Growth Centre workshop in Lusaka, Shah—echoing the 2010 Zambian Business Survey—suggested while much of the informal sector was characterised by microenterprises which should “disappear” there were also larger MSMEs which were, by contrast, characterised by higher rate of productivity better educational levels of entrepreneurs.3 Indeed, a closer analysis reveals that the informal sector in Zambia is not exclusively a residual sector with low productivity survival enterprises only, and that larger informal sector firms are run by entrepreneurs with higher education and greater access to infrastructure and banking facilities.

Shah and Conway (2010) therefore argue that the following interventions can encourage growth in this sub-sector:

Increased access to banking and lending services: Their results show that firms in districts with banking and lending services access are more productive than others. In addition, there is a positive correlation between the firms use of banking and lending services and productivity.

Improvements in infrastructure: Their productivity analysis shows that agricultural and nonagricultural firms are far more productive when they have access to infrastructure—electricity, cellphones, and water. Improvements to the transport network are also essential: almost half of the 41% of MSME owners that take their products to customers or markets reported that they spend between one hour and one day transporting them.

Improvements in education: MSMEs with better educated owners are more productive than other MSMEs in both the agricultural and non-agricultural sectors. Many of the MSME owners, however, only have basic levels of education—especially in rural areas. About half of MSME owners in rural areas have no education or only a primary education and about 45% have only a secondary education. Very few have any vocational training in rural areas and virtually none have a university education in either urban or rural areas. In addition to the direct effect of improving education, there are also strong complementarities between education and other forms of investment. The return to improving physical infrastructure—whether for irrigation or access to cellphone banking—will be lower unless concomitant investments in education are made. Indeed, studies suggest there is a strong appetite among informal sector workers for improved training (Haan 2001, Kanene 2001, Afro Development Services 1995).

Enhancing business facilitation: their results indicate that interventions that increase business facilitation including availability of cellphones and internet, business networks, training in financial record keeping and so on will lead to increased efficiency and competitiveness of Zambian MSMEs.

These sentiments were echoed by Chileshe Kapwepwe, Zambia’s Deputy Minister of Finance in 2010 (Zambia News Features 2010), who observes that:

Even if more Small and Medium Enterprises (SMEs) wished to modernise their plant and equipment, they would find it hard to do so because of the difficulty of obtaining financing. Many banks choose not to provide credit to SMEs as they are perceived to be the most risky and least profitable business sector.

She observed that banks that would want to make such loans available lacked the local knowledge of how to make small loans and package them appropriately. As such there was need for African countries to provide more information to lending institutions so that they could make financing available.

In addition, Minister Kapwepwe noted the importance of training young entrepreneurs (not least to encourage the confidence of banks), the need to develop other financial instruments such as bonds, improvements in infrastructure and a reduction of the bureaucracy involved in starting a new business.4

The taxation potential from such successful sorts of enterprises is, they argue, highly significant at present. Currently, only 5% of such firms are registered for VAT with only 2% reporting having a cash register. However, 63% of such firms report buying inputs from other businesses or government indicating possible liability for VAT payments. Therefore, by encouraging these kinds of enterprises and increasing tax compliance, a double benefit of increased incomes per worker and increased revenues could be achieved.

3.5.3 Equitable change

While continued tax reform and the encouragement of larger-scale MSMEs are clearly important, it is crucial to be realistic about the sheer scale of the informal sector in Zambia, and the potential for change in the short term. A recent editorial in the Lusaka Times complained that the lack of investment in the infrastructure in which the informal sector operates—in this case “Zambia’s flooded markets where consumers have to swim to get there”—can breed resentment about the spending of the revenues which are collected. This, the editorial argues, is “why most traders engage in curbside hawking”. The editorial goes onto state that:

The need to develop Zambia’s infrastructure to ensure meaningful economic growth takes place, is often talked about but almost never implemented. It’s disheartening to see the informal sector which is part of the rhythm of urban life and provides an insight into our country’s culture, food, smells and sounds being neglected. The state of Zambia’s flooded markets where consumers have to swim to get there, clearly say quite a bit about the management of revenue being collected from the market traders and tax payers as a whole. The traditional ways of earning a living in the informal sector need to be protected and supported particularly at a time when this sector plays an important role in providing employment.

Shopping malls have certainly given our cities a facelift but nothing compares to the African-ness of haggling in the market and the camaraderie that goes on as people interact. Our markets need to be places we can take pride in and entice tourists to visit, for a taste of our culture. In Africa, “when you visit a town and have not visited the market, you have not really visited the town.”

As such, it seems fair to suggest that there is a strong need to engage with the existing informal sector, not least through improving infrastructure in a “step-by-step” approach to ensure equitable change.

4. Conclusion

This case study of Zambia has sought to highlight the complexity of the issues surrounding the taxation and regulation of the informal sector in one Least Developed Country. Firstly, there are clearly issues of definition. One could easily argue that simply including a company in the taxation system does not automatically render it “formal” in the sense that so many of the other features of “informal” work—as associated with “vulnerable employment”—including lack of social protection, risky working conditions, low job security, difficulty in accessing credit, reliance on family labour and so on. As such, it is possible to argue that the strict differentiation between “formal” and “informal” is less useful than considering a “spectrum of formality” from the kerbside trader to the multinational business.

As such, including the informal sector in the tax system will bring these MSMEs one step closer to formality. However, investment in infrastructure, education and the implementation of the others measures discussed here would push these MSMEs further along the spectrum and, thus, increasing potential tax revenue. In this view, the issue of taxation cannot—and should not—be separated out from the broader development and human capital agenda.

12 April 2012

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