The Hidden Costs of Simplified Tax Systems: Challenges for Small Enterprises in Sub-Saharan Africa

The study highlights the challenges in designing simplified tax regimes for small businesses in Sub-Saharan Africa, revealing trade-offs between simplicity, equity, and revenue collection. It emphasizes that despite efforts, these regimes often disproportionately burden smaller businesses and fail to meet their intended goals.

A recent World Bank Policy Research Working Paper, authored by researchers from the Macroeconomics, Trade and Investment Global Practice, delves into the complexities of designing simplified tax regimes (STRs) for small businesses across Sub-Saharan Africa. The research explores the challenges policymakers face when trying to balance simplicity, equity, and revenue collection. STRs, such as turnover or presumptive tax regimes, are used by two-thirds of countries in the region, but their design and implementation reveal significant trade-offs. While these regimes aim to make tax compliance easier for small businesses and encourage revenue collection, the actual outcomes often fall short due to the diverse ways these systems are applied and the responses of small businesses.

Small Businesses' Struggles with Simplified Tax Regimes

The paper begins by highlighting that small businesses are crucial to the livelihoods of many households in Sub-Saharan Africa, yet they contribute only a modest portion of total tax revenue. Policymakers have responded by creating STRs, hoping that simplified regimes would encourage businesses to formalize and contribute to the tax system. However, the authors point out that many small businesses lack awareness of important design features, such as exemption thresholds, and that their reactions to tax increases are often counterproductive. For example, when faced with higher tax rates, businesses tend to lower their declared turnover in an attempt to reduce their tax burden, thus undermining the potential for increased revenue collection. This pattern was particularly evident in Kenya, where a detailed case study of the country’s turnover tax (TOT) regime was conducted.

Knowledge Gaps Leading to Unnecessary Tax Payments

Kenya’s TOT regime, like similar systems in other countries, is designed to ease tax compliance for small businesses by calculating taxes as a percentage of their turnover. Yet, the analysis shows that many small businesses, despite being below the minimum exemption threshold, still file and pay taxes. This behavior is attributed to a lack of knowledge or a fear of penalties, even when businesses should be exempt. The authors found that around 70% of Kenyan businesses that pay TOT should technically be exempt, yet these businesses collectively account for about a third of the total taxes collected under the regime. This highlights a major flaw in the system—while it simplifies tax compliance on paper, it does not adequately address the knowledge gaps among small businesses.

Response to Tax Increases: A Drop in Declared Turnover

The study also looked at how businesses respond to changes in tax rates. When Kenya increased its TOT rate from 1% to 3% in 2023, the researchers observed that businesses quickly responded by lowering their declared turnover, reducing the effectiveness of the tax rate increase. While the total tax collected did rise, it was less than proportional to the increase in the tax rate due to this strategic behavior by businesses. This kind of reaction not only limits the potential for additional revenue but also exacerbates inequality, as businesses with higher turnovers are better equipped to navigate these changes, leaving smaller businesses disproportionately burdened.

Testing an Alternative: Set Fees Based on Business Type and Location

To explore possible alternatives, the researchers conducted a randomized experiment in Kenya involving over 10,000 registered taxpayers. The experiment tested a new design where businesses were encouraged to pay a set fee based on their business type and location, rather than calculating taxes as a percentage of their turnover. This simplified approach was intended to reduce the cognitive load on small businesses and improve compliance. The results showed that offering clear guidance about expected payments could indeed increase tax revenue. Taxpayers in the treatment group paid an average of nearly 20% more than those in the control group. However, the study also found that this approach had an unintended consequence it disproportionately affected smaller businesses. While the simplified regime increased the amount of tax collected, it did so primarily by raising the tax burden on businesses with lower turnovers, thus reducing equity among taxpayers.

A Regional Perspective on Simplified Tax Regimes

Across Sub-Saharan Africa, the design of STRs varies significantly. Some countries impose a set fee on all small businesses, while others use a percentage of turnover or a combination of both. Only 40% of the countries with STRs implement a minimum turnover threshold, meaning many very small businesses are required to pay taxes from their first dollar of revenue. This approach imposes a heavy burden on the smallest businesses and complicates administration for tax authorities. Moreover, the relative size of the tax obligations under STRs varies widely across the region. In some countries, the effective tax rate for small businesses under STRs is far higher than what larger businesses pay under corporate income tax regimes, creating inequities in the system.

The findings of this study raise important questions about the effectiveness of taxing small businesses, especially in regions where many of these businesses operate at or below the poverty line. While simplified tax regimes can make it easier for small businesses to comply with tax laws, they often do not achieve their intended goals. Instead, they may place an unfair burden on the smallest businesses and fail to collect meaningful amounts of revenue. The paper concludes that, given the limited revenue potential and the significant trade-offs between simplicity and equity, policymakers should carefully reconsider whether it is worth taxing small businesses under STRs at all.