Does business formalization increase tax revenue?

by Christopher Kiiza
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By Christopher KiizaMany governments around the world enforce formalization of businesses to increase revenue collections and enhance fiscal sustainability.

This strategy aims to broaden the tax base by integrating informal enterprises into the formal sector, as informal businesses often evade direct tax contributions. 

Informal businesses, prevalent in both developed and developing economies, operate outside formal legal and regulatory frameworks. 

Often characterized by their unregistered status, lack of tax payments, and informally employed workers, these enterprises play a significant role in economies worldwide.

Informal businesses range from street vendors and small-scale service providers to clandestine manufacturing operations.

 Formalization of businesses involves transitioning these informal enterprises into legally recognized and regulated entities.

 This process entails registering with government authorities, complying with tax obligations, adhering to labor laws, and obtaining necessary licenses and permits.

Many experts argue that formalization of informal businesses is the only way that can increase revenue because informal businesses don’t pay taxes.

Senior Economist and Makerere University lecturer, Dr Fred Muhumuza disagrees.

“This does not mean that the informal people do not pay tax. They do. The water they drink, the water they use at their homes, there is VAT on all these kinds of things. So, there is already a wrong notion that formalizing businesses and the economy is what will increase tax revenues. That is wrong,” he says.

Tax collection mainly involves income tax, covering both personal and business earnings, particularly from profitable businesses.

In enforcing tax compliance, authorities often use iron fist and compel informal businesses to go formal which in some cases lead to business closure.

“I may not have records and have not paid taxes, but even if I had my records and you looked at them, you too will agree with me that I was right because I made no business profit. So, to just jump in and close [the business] without knowing the context of why this person did not pay taxes is missing the point,” says Muhumuza.

How Can URA Increase Tax Collections?

Muhumuza says understanding the above context is critical for government to set a tax collections target for the Uganda Revenue Authority (URA).

This is because every financial year, (URA) is given a target of tax revenue collections it should achieve in relation to the national budget of that fiscal year. At times, URA fails to hit the target.

For instance, the budget estimates for the 2024/25 financial year is 52.7 trillion shillings. Out of the 52.7 trillion, government plans to mobilize 29.9 trillion in domestic revenue. 

The URA will be tasked to collect 27.7 trillion shillings (93%) of the domestic revenue collections.

Government often sets target for URA after summing up the non-tax revenues and finances received from donors in form of loans and grants.

“You are really giving URA a nightmare of getting a tooth of crocodile. It is not an easy thing to do. That context should be forming the targets you (government) are giving to URA, and once you do that, you are able to say, can I scale down my budget from 52 [trillion shillings],” says Muhumuza.

Uganda has a structure of the economy where tax revenues are not speaking to the reality of supporting the entities that grow the economy for government to tax more.

A big portion of Uganda’s revenue collection goes to debt servicing. For instance, a whooping 17 trillion of the 52.7 trillion shillings budget for the 2023/24 financial year was allocated to debt repayment, taking the biggest chuck of the budget.

Additionally, Uganda spends huge sums of its budget on areas that are not taxed, which further complicate the tax man’s efforts to hit the revenue collections target.

“That is not speaking to the current needs of the economy and the businesses you are seeing. A [big] portion of it (the budget) is going to go into area we call pre-conditions. You are going to spend money on security. Most of the security operations do not pay tax, but they are the enabler of these businesses we are talking about to perform well and pay taxes,” says Muhumuza.

He adds: “we also have incentives where Uganda has locked the bulk of its money into what we call stock. Tax is on the flow. [For instance], if you exited this building, it will not pay any tax. What pays tax here is the rent you pay (rental tax). For most of the buildings in Uganda that are not being used, it is stock. And we have seen a lot of that in land, real estate, and even in government investments. If you get that context on the ground, then you will begin to see that the flow in this economy is so small, and it is only the flow that you can tax. So, you are not going to get the tax to GDP like Australian, the UK because for them, the bulk of their GDP is actually moving around and performing, and in that process can be taxed.”

Who To Blame Over Low Tax Revenue Collections

“I don’t want to blame URA necessarily, they have their own inefficiencies, I don’t want them to go off the hook, but they are not entirely responsible for the low tax revenue. The policy is where you want to go back; who gives them the target? But also, tax is supposed to be developmental. You want to get to this business and say you have arrears of taxes for the last five years; however, you can’t pay them and survive. How do we move forward,” says Muhumuza.

Muhumuza advises that URA not being a policy making institution, should share such information with the policy making organs – in this case the ministry of finance to set policies that facilitate businesses to clear their tax arrears gradually in order not to collapse.

“So, we need to broaden that tax policy, partly to raise revenue for the government, but mainly to grow the tax base that eventually generates more revenue. And that is more than URA’s mandate. It goes back to the Ministry of Finance; what policies are we making within the context of the Ugandan economy”

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