Tax Policy and Enterprise Development
in South Asia

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Problem and Justification

  Inclusive growth continues to remain a challenge for South Asian economies. The recent growth spurt experienced by Pakistan, India, Bangladesh, Sri Lanka, and Nepal has been accompanied (to varying degrees) by rising inequality. This fact is also reflected in the poor poverty reduction performance of these countries. Despite being one of the fastest growing regions in the world, South Asia still accounts for about a fifth of the world’s poor, with higher poverty rates than any other region (43%), including Sub-Saharan Africa (39%). Experts now agree that the missing link between growth and inclusivity is labor market outcomes that generate well-paying and productive jobs. This is exactly where South Asian economies have a poor track record. Even for economies such as India, which have recently posted some of the highest growth rates in the world, the transition of the labor force from employment characterized by low productivity and low wages to more productive and well-paid jobs has been slow and difficult.

  Most non-agricultural employment in South Asia is concentrated in small enterprises characterized by very low productivity and wages. The development of small and medium sized enterprises (SMEs) in these countries is arguably lagging, and with it their potential for creating productive jobs. While there is a large and growing body of research on entrepreneurship and enterprise performance, the role played by policy and institutional environment in influencing innovation, job creation, productivity increases, and market performance is not clearly understood. In particular, the role of tax policy needs to be explored in this regard.

  Research indicates that enterprise development and employment generation is strongly linked to tax policy. Tax policies provide the incentive/disincentive structures that determine compliance with the taxation system. Non-compliance places SMEs at a considerable disadvantage. First, SMEs not registered for taxation may not entirely escape taxation. In fact, they may bear an indirect tax burden that depends on the extent to which they purchase inputs from registered enterprises, and this may raise their marginal effective tax rates to exceptional levels. Even with direct taxes, non-compliance may not be costless. In India for instance, non-filer compliance costs amount to 3.4% of non-corporate income tax collections. Around 75% of these costs are due to foregone consumption benefits, 30% due to income loss from distorted investment, and 5% from expected non-filing penalties.

  Second, the potential for growth is reduced for non-compliant SMEs. The need for advertising must be weighed with the need to maintain a low profile. Obtaining formal licenses, certificates, and permits from local and other government agencies becomes difficult. They may also lose the government as a potential client, due to the requirements of tax clearance certificates, and also find it difficult to transact with formally registered enterprises. Formal sources of credit may also be barred to them, given the lack of tax certifications which is a common requirement. This may force borrowing at extortionate rates and conditions from informal sources. Non-compliant SMEs operating in the undocumented economy outside the tax net, therefore, become trapped in a subscale, inefficient work dynamic which weighs down their productivity levels to half or even less than that of their formally registered counterparts. Third, non-compliance with taxation may also distort competition by allowing inefficient enterprises to undercut the market share of more productive firms. Ultimately, this would hamper enterprise performance and entrepreneurship for the entire SME sector.

  These findings are supported by business surveys carried out in developing countries. The World Bank’s Paying Taxes Report finds that tax systems rank among the top 5 obstacles to the conduct of business in 90% of surveyed countries. Reasons include large number of taxes, complicated policy and administration, and high tax rates. The Report finds a direct relationship between inadequate taxation and the decision by enterprises to remain outside the formal tax net. South Asia is a particularly poor performer in this regard, with one of the highest annual number of tax payments, time requirements for tax compliance, and tax rates as a percentage of firm’s profits, worldwide. Sri Lanka for instance requires an annual 62 payments for an entrepreneur to pay taxes, as compared to 1 payment in Maldives. In Pakistan, firms must spend 560 hours per year preparing and filing returns and paying taxes, compared to 227 hours in East Asia and the Pacific. India levies taxes on entrepreneurs that constitute 65% of their profits, as compared to 32% in the Middle East and North Africa. These factors raise compliance costs that may be regressive and put a disproportional burden on small businesses. For instance, in Pakistan, 67% of SMEs term tax regulations as most problematic, while 28% feel that taxes in the country are too high. Smaller Pakistani firms find tax related issues more restrictive than larger firms; 69% of SMEs, whose size of assets was less than PKR 1 million face the greatest number of tax related problems. Many small firms claim it is not possible for them to maintain books as per law or hire a professional due to resource constraints.

  This may set in motion a vicious cycle where firms are pushed into non-compliance, forcing the government to collect more revenue from an ever-shrinking formally registered sector. All stakeholders in this equation will potentially lose out. Compliant enterprises would be further disadvantaged as the competitive edge of non-compliant businesses is magnified. The pool of after-tax earnings that can be re-invested to enhance productivity may also dry up. Enterprise performance and the productivity of entrepreneurial activity would thus be hampered. The government’s capacity to fund adequate public services and social protection may be reduced. Under fiscal pressure, governments may resort to inflationary borrowing and unsustainable debt. This may in turn necessitate money supply reduction and increased interest rates which will hamper credit creation and investment. This would make it difficult for small enterprises to grow and create the productive and well-paying jobs that can make inclusive growth achievable. Among the key taxation issues linked to the development of small enterprises and by extension the creation of productive, well-paying jobs in the South Asian context are: tax exemptions and concessions, Value Added Tax (VAT) reforms, and local property taxes.

  First, tax exemptions and concessions are largely skewed to favor large enterprises. The ILO reports: “Supply-side support provided by the government [including] tax holidays… are normally biased in favour of larger industrial enterprises and may not only prevent smaller enterprises from developing their potential or gaining access to global markets, but may also lead to the displacement of informal operators and workers.” Though officially designed to meet various policy goals, their efficacy becomes difficult to judge, as tax expenditures are not subject to the same scrutiny, political debate, or public attention as direct spending. This opacity creates the space for rent-seeking lobbies that serve the interests of large enterprises, at the expense of SMEs, especially those operating outside the tax net in the undocumented economy. This arguably impacts SME development, entrepreneurship, and reduces the opportunities for generating employment-intensive growth.

  For instance, in Sri Lanka, tariff policies favoring the coir industry shifted the supply of coconut husks to mechanized units owned by men with access to credit, away from manual units owned by women lacking this access. In Pakistan historical and current tax policy evidently purveys rents to large-scale manufacturers. Frequently changing SROs favor large firms over smaller ones. Export rebates and other concessions are largely inaccessible to small sub-contractors. Direct exporters are exempt from filing income tax returns, as banks will provide these services, whereas smaller sub-contractors must incur these costs, in most cases. Large firms located in special industrialized zones are waived customs duties and sales tax on import of inputs. Micro, small and medium enterprises are not afforded the same oppurtunities. There is even evidence of undue harassment of small firms regarding income tax assessment by tax authorities. In India, small enterprises operating in the undocumented economy are provided a “special” rather than “level” playing field through the creation of Special Economic Zones that cater to large corporate entities. These Zones feature comprehensive tax holidays of 5 years, 50% tax exemptions for the next 5 years, and 50% exemption on re-invested profits for the following 5 years.

  There is also evidence linking biased tax regimes to the emigration of entrepreneurs and skilled workers to friendlier tax climates. This may deplete the level of entrepreneurship with losses in productivity, reduce the potential for innovation, and the ability to create productive jobs associated with entrepreneurial activity. It may also amount to a ‘brain drain’ and deskilling of the labor supply in the country of origin, creating skill shortages, depressing productivity, and constraining market performance. In Pakistan, the emigration rate of individuals with a tertiary education to OECD countries is more than 7%. A recent Gallup survey reveals that 38% of working adults (skilled and semi-skilled) would prefer to settle permanently outside Pakistan. These figures do not take into account the growing outflow of skilled labor to the Middle East, particularly the UAE. Over 6000 Pakistani firms are now operating in this region. Similarly, over 150 Indian companies are operating in Hong Kong and mainland China, attracted by friendlier taxation laws.

  International experience suggests that policy processes in their political dimensions are as important as policy outcomes. Yet, analysis of revenue systems from political economy perspectives remains sparse in South Asian countries. Without it narrow interest groups with political influence may continue to capture policy agendas. Research needs to be conducted, which provides a detailed, explicit stocktaking of how SME development is affected by tax exemptions and incentives, the roles of lobbies and interest groups in this regard, and to explore the ways in which the welfare impacts of tax expenditures can be maximized for the SME sector, allowing them to create productive jobs to make growth more inclusive.

  Second, enterprise development is affected by taxes such as the Value Added Tax (VAT). However, research on the nature and magnitude of this impact is on the whole ambiguous. Mainstream policy advice to South Asian countries has advocated the introduction of VAT or raising VAT rates to compensate for the losses associated with liberalized trade regimes. However, research presents no straightforward endorsement of such reforms. Certain studies indicate that the introduction of indirect taxes (e.g. VAT, GST) pushes entrepreneurs toward non-compliance with the taxation system. Small enterprises that are already operating in the undocumented economy will not be able to pass on the VAT to their consumers given that they cater to highly competitive and price sensitive markets. Research also finds that given the presence of a large undocumented economy, VAT reform reduces both welfare and revenue. On the other hand, researchers argue that for non-compliant entrepreneurs, the VAT is in effect an import tariff, as they are not registered under VAT regulations, and so cannot claim input credits. Others argue that input credits themselves may entice enterprises to formally register. What may be reasonably concluded is that non-compliance would be reduced if the VAT reform is successful, as under a revenue neutral model, documentation of the economy would be necessary to generate more revenue.

  But it is empirically unclear if tax compliance has been reduced or increased by VAT introduction in South Asian economies, which in turn raises questions concerning the success of VAT reforms. Pakistan is set to upgrade to a full-fledged VAT despite more than a decade of lack-luster performance under a quasi-VAT Sales Tax regime introduced in 1990. Commentators have already predicted that the tax would potentially lower collection receipts and push more enterprises into non-compliance with the taxation system. The VAT in Bangladesh is a strong earner but with evidently regressive distributional impacts. In Sri Lanka, experts have noted that the strong role of the non-compliant enterprises and the large number of undocumented transactions may have complicated VAT implementation. After 8 years of operation, VAT revenue performance in the country remains sub-par in comparison to the taxes it replaced. Experts have noted that in India, the large number of undocumented transactions implies that formally registered traders who invoice their sales may end up bearing the tax burden of the entire preceding informal value chain, under the VAT regime. Thus far, the VAT has resulted in a loss of revenue for 10 states, and many manufacturers did not pass on the benefits of lower tax rates to consumers. This heterogeneity of experience with essentially the same tax regime across the region raises various questions.

  However, there is little in the way of detailed economic analysis by governments, think-tanks, or independent researchers on the impacts of such reforms on enterprise development and labor markets. Without this knowledge, it is difficult to assess prospects for improving the regulatory and policy framework, ascertain implications for parameters such as growth and inclusion, entrepreneurship and productivity, and the creation of productive jobs in South Asia. Given this shared experience of VAT, there is added value in collaborative research on this issue conducted by think tanks throughout the region. It will allow them to crystallize learning experiences, flag pitfalls for governments attempting new reforms, and share best practices on reform design, execution and sequencing.

  Third, enterprise development is affected by weak local property taxation. Enterprises operating on informally developed land cannot access mortgage-backed finance. Informal land development itself can be reversed through effective property taxation in a number of ways. Levied on land value, property taxes can potentially pull the existing stock of serviced land to the market. Enterprises and workers excluded from social services and state attention would thus be brought into the formal sphere. It may also bring down land prices through the capitalization effect, placing it within the affordability limits of entrepreneurs and SMEs. Additionally, without effective property taxation to establish formal property rights, key opportunities to enhance employment intensive growth, which leads to more and productive jobs, become difficult to avail. For instance, the World Bank advocates the provision of access to housing finance to households in informal settlements as a key solution, which can trigger housing industry growth that may bring 3.2 million new jobs over the next decade. In India, such proposals are already in the pipeline with the potential to build houses for up to 28 million households. However, without effective property taxation to establish formal property rights, housing finance will remain difficult to access. Research on the issue in the South Asian context is limited to a handful of studies on informal land and housing markets, despite the strong prevalence of these problems in South Asian countries.

  The gender dimension of enterprise development in South Asia has been ignored in policy and research. This is despite the significant statistical overlap between being a woman, working in the undocumented economy, and being poor, in South Asia. The link between informal employment and poverty is stronger for women. Not only are women over-represented in the undocumented economy, they are over-represented in the lower-income segments of casual wage or home workers. In the higher-income segments of self-employment or employers, their involvement is concentrated in sub-scale operations with less growth potential than those performed by men. Women entrepreneurs and workers are therefore relegated to unproductive, lower-paid employment options with inadequate legal recognition or protection, labor rights, social protection, and voice. Inadequate taxation policies may either perpetuate these contrasts or further sharpen them. In addition to the biases that shut out SMEs from tax exemptions and concessions available to large enterprises, SMEs managed or owned by women, especially those operating in the undocumented economy, must face a host of other difficulties.

  For instance, in Pakistan, most women entrepreneurs are trapped in household-based, low-return, unpredictable markets where growth prospects are limited. Enterprises managed by women are largely characterized by higher closure rates, and lack sufficient access to essential inputs such as finance, skills, and marketing channels. A study conducted last year found that women in the undocumented economy did not figure largely (if at all) in tax policy and administration, and in budgeting and planning at the local, provincial and federal levels in Pakistan. These women are far more likely to be unpaid family workers than own enterprises, when compared to men. They are also found, overall, to work longer hours for less pay, and are motivated by poverty.

  In India, women entrepreneurs grapple with similar issues. They lack sufficient access to credit, as the incentives open to other enterprises are more difficult for them to obtain. They also lack formal operating spaces and most face harassment from local authorities. Overall, their work continues to remain a legal offshoot of their households rather than an independent entity. They must contend with a host of health and safety risks such as unsafe working environments and gender-based violence. And their productivity is limited by the non-availability of infrastructure, space and time. Women entrepreneurs in Bangladesh, generally face harassment in dealings with the government, banks, lenders, and clients. Cumbersome legal and regulatory requirements such as obtaining tax certificates and trade licenses, (among others) are more difficult to meet for women entrepreneurs, limiting their potential for growth.

  In Nepal’s undocumented economy, only 17% of the female population owns productive assets, which makes institutional borrowing largely inaccessible and entrepreneurship improbable. Women workers work 77 hours a week compared to 56% for men , with marked contrasts in wages for similar work. Lack of child-care facilities, and discrimination in terms of opportunities for employment, training, promotion, and credit availability are commonly faced difficulties. They may also be exposed to sexual harassment, exploitation and trafficking. Overall, women in Nepal’s undocumented economy lack access to education and information, markets, safe working conditions, and face the “progressive loss of proprietorship”. In Bangladesh, women entrepreneurs are generally discriminated against at the family, market and community levels. They are thus excluded from opportunities for entrepreneurship and productive work. These conditions may create entry barriers to entrepreneurship for women, and limit the development of women-led enterprises. In doing so, they may also constrict their potential for innovation, growth, and the creation of productive jobs.

  What is needed now is a collaborative effort by the leading think-tanks of the region, to conduct empirical research on tax policy and its relationship to enterprise development and inclusive growth, at the national and regional levels. This research would fill research gaps, inform policy, and provide opportunities for shared learning outcomes at the regional level.
 

 

(C) 2012 at GINI, Islamabad-Pakistan