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Rebuilding The Fiscal Contract? 5 Innovative Ways to Tax Informality

13 Dec 2017


Rebuilding The Fiscal Contract? 5 Innovative Ways to Tax Informality
Strengthening domestic resource mobilization (DRM) is seen as an imperative for implementing the Sustainable Development Goals, and arguably the most important aspect of DRM is taxation. Given the renewed focus on DRM in the Addis Ababa Action Agenda, there is currently a lot of discussion around taxation and its role in financing development. What is less clear, however, is how countries can implement tax reforms within often unfavourable structural contexts. In addition to a lack of tax reform, the size of the informal economy is often seen as an obstacle to increasing tax revenue—particularly in parts of Sub-Saharan Africa, where the informal economy accounts for up to 94 percent of non-agricultural employment . Yet, based on a qualitative study on the informal economy in Ghana, Joshi and Ayee postulate that informal actors are not averse to taxation if it brings benefits, and prevents harassment by police and inspectors. So why is this putative social contract not working? This think piece explores the potential to rebuild a social contract between informal workers and the state, refilling coffers to finance social development and providing social protection to those who lack formal access to it.

Maudo Jallow has worked for the LSE Africa Summit, UNDP Uganda - Strategy and Policy Unit, Alliance 54 and Press TV UK. He holds a Bachelor's degree in International Business with French and Economics and has completed a Master's degree in African Development from the London School of Economics and Political Science. At the time of writing he was a research intern at UNRISD.

The high cost of taxing informality


Attempts have been made in the past to tax the informal economy, and they are often burdensome for both the tax payer and the tax collector. For example, in order to tax the large informal economy in Zambia, a flat three percent tax was introduced in 2004, which only made the poorest in society even poorer, as they could not afford to comply (an example of “adverse incorporation”). Avoiding taxes that cut into already meagre incomes is cited as one of the main reasons some people choose to operate informally in the first place.

Taxing the informal economy can also leave informal actors vulnerable to coercion. When conducting research on the political economy of domestic resource mobilization in Uganda in 2017 for a Master’s thesis in African Development, I found that a weak tax administration led, in the past, to coercive tactics (for example, tax raids involving the police or military) to ensure compliance. In recent years, reforms have been made to strengthen the tax administration in order to avoid these practices, boost tax collection and increase transparency. The Uganda Revenue Authority has implemented a more transparent, accountable and business-friendly tax regime—thanks to its automated Integrated Tax Administration System and training from the World Bank and the IMF. However, challenges remain.

As a result of these challenges, some economists (such as Emran and Stiglitz) advocate prioritizing other revenue sources, for example taxes on trade, as governments tend to gain very little revenue when they tax informal activities, and in some cases the costs of collecting these taxes are higher than the revenue collected.

Is it worth it?


The political case for taxing the informal economy is simple and seems logical: by paying taxes, informal actors gain political voice and ways to hold governments accountable . It is also believed to restrict the use of patronage politics and break what is known as the “Devil’s Deal”—when the state avoids taxing certain sectors or activities in order to gain political support. Vitally, taxation helps construct a social contract which is essential for state building and human development. When this link between the state and informal workers is established, they become visible to the state which should then include them in service provision and regulatory frameworks.

However, scholars like Kate Meagher view these arguments as devoid of historical context and based almost entirely on theory, because they ignore the realities of power relations between formal and informal economic actors. Evidence from Meagher’s work in Nigeria shows how informal actors—especially women, immigrants and minority groups—do not necessarily gain political voice and the ability to hold governments accountable by paying taxes. Despite an established contract between the state and its citizens, it is still possible for governments to exploit power imbalances, for instance, when parliamentarians within the ruling NRM party in Uganda strategically pressure the Uganda Revenue Authority to stop taxing certain regions, sectors or ethnic groups in order to gain support.

Innovative approaches to just taxation


Given the criticisms of the current methods of taxing the informal sector, a new approach is needed which does not overlook power relations between the relevant stakeholders. There are a number of promising initiatives and innovative approaches that policy makers would do well to pay attention to:
  1. When informal workers organize themselves in associations, these groups can at least partially address power asymmetries between the tax collector and informal actors, to the benefit of both sides. Agarwala notes that informal workers in India “managed to attain some welfare protections and benefits from the state” thanks to the work of SEWA (Self Employed Women's Association). Critics of this approach argue, however, that such workers’ associations are often captured by the state and delegitimized in the eyes of their members.
  2. The “holistic” approach, advocated by organizations like WIEGO, is slowly gaining popularity in academic and policy-making circles. It aims to empower and support the dynamism of the informal economy, as opposed to aggressively formalizing its activities. One concrete way to implement this is for the state to require companies that use the services of informal labour to provide social protection for those workers. Additionally, states need to recognize informal workspaces, which can go a long way in reducing the vulnerability of informal actors to harassment, crime, violence and unsafe working conditions. Informal workers want recognition, social protection and the right to organize. Therefore, policy makers should take a human rights-based approach, expanding labour rights and social protection to the informal economy, instead of simply taxing informal workers without providing benefits in return.
  3. A more long-term solution is to improve the capacity of tax administrations so that they are better equipped to fairly and efficiently collect tax from informal actors, rather than privatizing tax collection and applying unrealistic taxes which has led to coercive tactics and a loss of trust, damaging the social contract.
  4. Taxing the goods and services that informal firms buy and sell has been proposed by authors like Anuradha Joshi. In countries with low state capacity and weak tax administrations, this can be done by authorizing certain large, trusted firms to withhold taxes on payments made to informal entities or individuals; the withheld taxes are then forwarded to the revenue authority. This has already been successfully implemented in Uganda and can be done alongside sales or value-added taxes that are not presumptive or arbitrary in nature. However, such a taxation system in which the relationship between the state and informal workers is mediated by business does not empower tax authorities and replicates power asymmetries, while not providing the possibilities for a reverse flow: that of social benefits from the state to workers.
  5. Technology can play a role in transforming how governments collect tax by making collection easier and cheaper. The Uganda Revenue Authority saw not only increases in tax collection, but higher levels of transparency and compliance as a result of their recently introduced automated tax systems. The voluntary Taxpayer Registration Expansion Scheme was deemed successful: there were 400,000 new registrants from the informal sector at the time of my 2017 Master’s research.

In conclusion, it is in the interest of both the state and informal actors to work on building a strong and sustainable fiscal and social contract that increases accountability and transparency, and enhances the productive capacities and well-being of informal workers. Once trust is built between the two entities and the dignity and rights of informal actors are protected, all stakeholders will benefit.

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This article reflects the views of the author(s) and does not necessarily represent those of the United Nations Research Institute for Social Development.