Broadening the Tax Base

Broadening the Tax Base: The Urgent Assignment for Ethiopia

At the end of the just ended fiscal year, Ethiopia’s parliament approved ETB320 billion budget for 2017/18 fiscal year. The Ethiopian Revenue and Customs Authority (ERCA) also planned to collect ETB199 billion in the year, 62Pct of the approved budget. The tax collection in the preceding year was ETB160 billion. The Authority has been working to increase the tax-to-gross domestic-product (GDP) ratio from 13Pct currently to 17Pct in 2020.
However, the recent effort to increase tax collection, thereby improve the tax-to-GDP ratio, by collecting more taxes ended up being controversial. Tax payers repeatedly voice their frustrations in high sales assessment which implies exaggerated tax amount to be required. Experts also challenge the way the government tries to boost domestic resource mobilisation because efforts to create an enabling business climate for small and informal businesses to go formal and contribute more to the national development endeavour remains minimum. EBR’s Samson Hailu explores the issue to offer this report.

The need to rely more on resources mobilized domestically is becoming essential for developing nations like Ethiopia due to the unreliable nature of external source of finance such as loan and aid. In light of this, Ethiopia has been pushing to boost domestic resource mobilization especially in tax collection in recent years.
For the new 2017/18 fiscal year, the Ethiopian Revenues and Customs Authority (ERCA), the government body responsible for collecting revenue from customs, duties and domestic taxes, planned to collect ETB199 billion, ETB39billion higher than the tax collected in the previous fiscal year. Achieving this target means contributing to the effort of increasing the tax-to-gross domestic product (GDP) ratio in the country to 17Pct threshold by 2020, which most Sub Saharan African countries have already achieved. Currently, tax-to-GDP ratio stands at 13Pct in Ethiopia.
But, not all the efforts of ERCA to increase the tax-to-GDP ratio by collecting more revenue goes unchallenged. Even in the final months of the just ended fiscal year, the Authority conducted new tax estimation to calculate yearly tax collections from small and medium traders registered as sole proprietors. However, the assessment faced fierce resistance from businesses in many parts of the country especially in the capital Addis Ababa. In fact the authority reported that more than 40Pct of the estimation was found to be erroneous.
Close to 150,000 businesses were included in the tax assessment conducted in June 2017 throughout the country, the first time since ERCA conducted the same assessment six years ago in Addis Ababa. After the assessment was finalised and the daily average sales estimation made public complaints started to surface.
Based on the revised income tax proclamation of 2016, a ‘Category-C’ taxpayers are sole proprietors with an annual gross income of less than ETB500,000. On the other hand, ‘Category-B’ taxpayers have an annual gross income between ETB 500,000 and ETB1 million. Category-A’ taxpayers represent sole proprietors with an annual gross income of more than ETB 1 million.
According to the data obtained from ERCA, 59,000 businesses under ‘Category-C’ were covered during the assessment in Addis Ababa. Yet, 26,000 of them filed formal complaints regarding the erroneous sales assessment made. They complained that the estimates are exaggerated and unrealistic.
A family owned warehouse rental business in Mercato, the biggest open market in Addis Ababa, managed by Million Yasin, was one of the businesses that went through the sales assessment process. The warehouse, which covers a total area of 200 square meters, is leased from the Agency for Government Houses more than 40 years ago.
“After having just a glance of the warehouse, the assessors told me that the average daily revenue is estimated to be ETB45,000, making a yearly revenue of over ETB16.2 million,” Million told EBR in frustration. “This means I have to pay ETB1.5 million profit tax per year, which is unjustifiable in any way.” He added.
Million claims he receives ETB3 to ETB5 per cartoon per day. “The actual daily income of the warehouse ranges between ETB500 to ETB1, 700. So I told the officers that my average sales is ETB1,330, which they did not accept.” ERCA’s estimate is 34 times what Million claims is his real average daily transaction.
Even small business owners like Yashemebet Aklilu who runs a cosmetics shop around Betel Hospital in Kolfe Keranyo District claim that the assessment was unfair. Yashemabet, a single mother of two, who pays ETB2,000 monthly rental for 12 square meter shop says her daily income has not exceed ETB600 in a good day. “However, the assessment officers from ERCA, increased it to ETB1,750,” she told EBR. “This increased my tax dues to ETB6,500 from the previous ETB2,000, which is unreasonable and beyond my capacity.” She lamented.
After receiving the grievances of many like Million and Yashemebet, ERCA announced in mid August 2017, just before the final deadline for tax payment for businesses under ‘Category-C’ that 98Pct of the businesses paid their taxes after the Authority made adjustment for most of the businesses that forwarded their compliants. However, both Million and Yashemebet claim that their grievances remained unaddressed.
Such disagreement between the tax authority and businesses is not unique to Addis Ababa. It is common to see small-business owners across the country under stress and frustration due to high tax rate. Countless hours and a lot of paper works are required just to file their taxes every year. Regularly ranked among the top issues facing small businesses are the ever-growing frustration they endure as a result of the several obsolete tax provisions, retroactive extensions and legalese per¬meating.
Yet, officials at ERCA stress that the assessment was made to include additional businesses in to the tax system and tax the businesses based on their up-to-date revenue. “The target of the assessment is to bring in [informal] businesses into the tax net and also collect more from existing ones because they are expected to have grown in the last six years,” explains Fasika Belay, deputy communications director at the Authority.
To justify the validity of the assessment Fasika explains the relatively low tax collection performance in the country that doesn’t match the rapid growth of the economy. “Though the economy has been growing, the tax that has been collected has been minimal.” He reiterated.
Development financing from domestic resources in general and tax revenues in particular is a critical success factor to achieve Ethiopia’s objective of joining middle income status by 2025. Tax revenue collection increased by 90Pct in the last five years reaching ETB160 billion in 2016/17 from ETB84.4 billion five years ago. Despite such achievement, there is still a potential gap not filled in mobilizing domestic resources so that the double digit economic growth that has been registering for more than 10 years can sustain for a reasonably long period of time.
Agreeing on the disproportionate growth of tax collection and the economy, experts challenge the way the government tries to rectify the problem. “The government tightens its grip only on businesses that are already in the tax net,” argues Desse Menbere, a private advocate and tax consultant who served ERCA at its legal department for seven years. “Rather, little has been done to expand the tax base and introduce new tax types.
Sven Steinmo, professor of political science at University of Colorado Boulder (USA), in his study entitled ‘Taxation and Democracy: Swedish, British and American Approaches to Financing the Modern State’ echoes the same opinion. He says governments need money and modern governments need lots of money. “But, how they get this money and whom they take it from are two of the most difficult political issues faced in any modern political economy”
Of course, studies conducted on the issue also reveal that the sustainable way of increasing tax collection is expanding the tax base instead of squishing the tax payers that are already in the tax system. In principle, the tax base means a taxable income and it is by creating more assets in the tax rolls such as new businesses, rental homes and properties, which can expand the tax base.
According to investopedia, a leading online source of financial content, broadening tax base entails nurturing those businesses and supporting them to become stronger financially so that more tax can be collected from them instead of discouraging their growth by asking them to pay unnecessary tax at their infant stage.
Yet, in Ethiopia, the effort to expand the tax base by encouraging micro and small businesses that operate in the formal and informal sector and enable them to contribute for tax collection endeavour, remains to be minimal. The number of taxpayers at national level stood at 1.2 million, for the last four years, without significant increase. Ten years after its introduction, there are only 161,286 cash register machine users throughout the country. This represents only 59Pct of the total 246,419 businesses that should have been using the technology. Electronic cash register machines help track customer transactions and keep accurate sales records if used properly and always whenever sales take place.
Despite the stagnant number of tax payers, profit tax from businesses jumped by 115Pct in the last five years and reached ETB31.6 billion in 2016/17. This means, business income tax showed 23Pct annual average increment in the last five years, without any significant number of businesses joining the tax system.
One area that discourages businesses’ ability to join the formal sector and limits the ability of businesses already included in the tax system to grow is the flat rate income tax levied on companies regardless of their sizes. According to the amended income tax proclamation, the rate of corporate income tax applicable to a company is 30Pct.
“To levy flat corporate income tax rate for businesses that contribute little in terms of employment creation and other economic benefits is a right thing to do,” argues Desse. “However, there are small businesses that can contribute a lot in terms of employment creation, export earning and collection of taxable income if the necessary support for their growth is provided.”
Of course, high tax rate is a problem for small businesses because it reduces the after-tax income that owners need to invest back in their business to ensure their continuity and growth as well as more job creation. Small businesses include both self-employed and sole proprietor traders. The former are taxed as individuals and the later are taxed as companies. Desse says micro and small businesses engaged in the industry (manufacturing) sector initiated by the private sector could be an example in this regard. “Although there are incentives, more support should be offered for indigenous micro and small businesses that have the potential to be the pillars of the economy.”
Experts argue that, tax incentives are useful to attract investment. However, they caution that it should be properly designed and implemented carefully. “Tax incentives are justified if they correct market inefficiencies or generate positive externalities,” says Desse.
However, the Office of the Prime Minister recently rejected a recommendation forwarded by the Ethiopian Development Research Institute that suggest a reduction of the corporate profit tax for manufacturers to 17Pct from the current flat rate of 30Pct for all sectors. The Institute also urged the government to look up on depreciation method and tax-deductible rates which is a common policy used in other countries to attract and retain investment in the manufacturing sector.
Desta Bezabih, director of Inland Tax Programme Development at ERCA argues that the government is doing everything to broaden the tax base. “The need for amending the income tax proclamation, which was approved by the parliament last year, is meant to expand the tax base.” He explains. “Even during the recently conducted sales assessment survey, more than 8,000 micro and small businesses were brought into the formal tax system under Category-C.”
The recently amended proclamation stipulates, among other issues, a new income tax rates which will be applicable to different types of incomes. For instance, the law increased the taxable minimum income threshold from ETB1,800 to ETB7,000.
Rental income tax is one of the taxes recently enforced especially after the amendment of the income tax proclamation in 2016. Even though rental income tax has been identified as one of the tax items in the previous tax proclamation, stronger enforcement in the area started as of recently. Although recent information is not available at ERCA tax collected from rental house income reached ETB1 million in 2015/16, from almost zero a year before.
In its 2016 article IV consultation report, the International Monetary Fund (IMF) stresses that the recently passed income tax law simplifies procedures, updates tax brackets, and improves the tax appeal process. The newly introduced invoice-based taxation of imports is an important step in modernizing customs procedures and trade facilitation. However, achieving the objectives in the second phase of the Growth and Transformation Plan 17Pct tax-to-GDP ratio by 2019/20 necessitates additional tax policy reforms, according to the report.
The necessary reforms include the introduction of a property tax and review of existing tax expenditures and incentives. Regarding tax administration, IMF recommends measures to focus on improving taxpayer coverage and enforcement, including updating and maintaining the taxpayer register; using risk-based compliance monitoring; and improving IT systems, data quality, and their use.
Indeed, experiences in some Sub Saharan African countries reveal that the reduction in tariffs has been successful, as increased imports have compensated for the reduction in tariffs and resulted in an increase in trade tax revenue. According to a study entitled ‘Increasing tax revenue in sub-Saharan Africa: The case of Kenya’ conducted by Nicholas Cheeseman, a lecturer in politics at St Peter’s College in Oxford and his colleague, found out that due to the structural weaknesses of the economy of most Sub Saharan African countries, the possibilities of revenue expansion is limited. Low levels of formal employment as well as the expansion of the informal sector, which are the main features of the Ethiopian economy, constrain the governments’ ability to increase income tax revenue.
Experts stress that especially the informal sector, which consists of firms and individuals who are not fully registered and regulated, and therefore not in the standard tax net, can be converted to the recorded economy through optimal tax policy. “But, the inclusion of businesses that used to operate in the informal sector in to formal one should be done to provide them the necessary support for growth instead of taxing them without considering their capacity,” warns Desse.
Friedrich Schneider, professor of economics at Johannes Kepler University of Linz, Austria, defines informal sector as one that includes all production of goods and services that are deliberately concealed from governments to avoid payment of income including value added or other taxes, to avoid payment of social security contributions and to avoid having to meet certain legal labour market standards, such as minimum wages, maximum working hours, and safety standards.
Although it garnered significantly increased attention, taxing small businesses in the informal sector remain difficult in recent years mostly due to the unavailability of concrete data about their size and features. Yet, a rare urban informal sector survey, which was conducted in January 2003 by the Central Statistical Authority, estimated that the amount of the hidden economy is about 28.2Pct.
Another study conducted by Emerta Asaminew, a researcher and graduate teaching assistant at the Oxford Brookes University, in 2010 entitled ‘The Underground Economy and Tax Evasion in Ethiopia: Implications for Tax Policy’ reveals that the informal sector reached to a high level of 33.3Pct in 2008 although the size of the informal economy declined to 30Pct between 1998 and 2006, on average. The data obtained from ERCA, on the other hand, indicates that there are an estimated 240,000 businesses in Addis Ababa alone operating in the informal sector.
Emerta suggests that this significant portion of the underground economy can be transformed to the formal sector through optimal tax policy. As a policy lesson for tax authorities and responsible bodies working for the development of formal micro and small businesses, “the innovation, technology transfer, employment, income, and growth roles of micro and small businesses increases as nations use more and more encouraging tax and subsidy policies.” The study stated.
But, experts stress that broadening the tax base through nurturing small businesses and modernizing the informal sector rely on the existence of efficient tax system, which needs structural and institutional reforms. Overhauling the management and structure, advancing customer focus services and provision of information technology supported services should take centre stage for reforms. EBR

5th Year • September 2017 • No. 54

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