The informal sector in developing countries comprises more than just unregistered street vendors and tiny businesses: it includes numerous established businesses employing hundreds of people across a diverse range of industries while going untaxed. Focusing on the experience of Uganda, this column explores how governments can use the tax system to reduce the extent of informality in the economy, while continuing to reap the benefits it brings in terms of entrepreneurship and skills development.
The informal sector accounts for a large proportion of Uganda’s economy in terms of jobs: 91% of non-farm employment, with young people (those aged between 18 and 30) occupying 95% of those jobs. This is too big yet very important as 60% of skills developed in the informal sector are a key part of the transition needed for developing economies.
In the financial year 2017/18, approximately 51% of Uganda’s total GDP was generated in the informal economy, where businesses are typically unregistered and thus not captured by the tax system. While estimates of the size of the informal economy vary, there is a substantial amount of economic activity that goes untaxed.
The informal sector comprises more than just the unregistered street vendors and tiny businesses in the markets. It also includes established businesses that employ hundreds of people in industries as diverse as trade, manufacturing, agriculture, forestry and fishing, hotels, restaurants and other eating places, transport and storage services, mining and quarrying.
Uganda’s government is aiming to reduce the share of the informal sector from 51% of the economy in 2018/19 to 45% in 2024/25 by increasing the competitiveness of the private sector and promoting sustainable inclusive growth. As such, it has put in place strategies to enable taxation of the informal sector. These taxes are both direct and indirect through formalization to push firms and individuals into the tax net.
Many businesses have been encouraged to formalize given the compensation received based on Value Added Tax (VAT) refund compared to the benefits of delivered public services. This has strengthened citizens’ tax morale, thus contributing to reducing the informal economy. The VAT refund has been done through the Electronic Fiscal Reporting Integrated System (EFRIS) where the process of application and verification has been streamlined.
Formalization encourages business growth, creates a better business environment, and helps to build a culture of tax compliance. Many businesses continue operating informal systems, yet those that have formalized keep many of their operations informal. One study reports that the legal environment plays a significant role in explaining tax evasion and informality.
Strategies to increase formalization
The government has put in place best practices to reduce the size of the informal sector and increase taxation. There are mandated organizations such as the Uganda Registration Service Bureau (URSB), which ensures that businesses obtain legal Identity/status by acquiring trade names. An e-licensing portal makes it possible for potential investors anywhere in the world to get information easily on any license that they need to operate from whichever part of Uganda in any sector.
The Kampala City Council Authority (KCCA) has reported the highest revenue collection growth of 16% in the financial year 2021/22. This was attributed to automated or digitized revenue processes, an e-cities system and identification of eligible taxpayers who previously were not paying taxes. This expanded the tax base, vigorous taxpayer sensitization campaigns using electronic, print media and workshops to educate citizens, and formation of a special unit to deal with large taxpayers.
The Uganda Revenue Authority (URA) introduced automation of the tax system, which eliminates corruption by building tax compliance and winning public confidence through improved service delivery. Tax procedures are simple and transparent. Taxpayers are also educated on tax laws and collection systems, which has enabled them to know their obligations.
The challenges still faced
Despite these strategies, Uganda still has a thriving informal sector of up to 80% of the economy, which leaves the burden of paying taxes to only 20% in the formal sector. This has the consequences of overburdening taxpayers, leading to tax avoidance and evasion, shrinking the tax base, and further widening the informality gap.
A recent assessment shows that despite the government’s efforts, there is still little awareness of digitization initiatives such as e-tax and other innovations. There are also infrastructural impediments such as poor internet and power connectivity that limit the innovations.
The persistence of informality is also attributed to lack of information on registration fees by non-registered businesses, and the number of days it takes for registration. In addition, the country lacks a uniform identification system for registered businesses, making it difficult to share and compare information across different agencies. Agencies are also at different levels of automation, with the majority still operating manual registers.
Full enforcement of taxation on the informal sector will increase labor productivity and output by reducing economic distortions. But it is unlikely that taxing the informal sector through formalization will bring in significant tax revenues in the short to medium term.
In general, businesses’ decisions about whether to formalize are based on several factors, such as analysis of the costs (which can include higher taxes) and benefits (such as growing the business through official advertising and access to credit markets). The various business constraints have implications for tax evasion and informality.
Empirical evidence shows that businesses tend to operate at a bigger level of informality when faced with transport, macroeconomic, and inadequately skilled manpower challenges. Further research shows that there is very low tax morale among small to medium-sized enterprises (SMEs) given that tax compliance attitudes are influenced by trust, knowledge of the tax regime, perspectives on public goods and service delivery, fairness and the authorities’ power in enforcing compliance.
While this sector presents a significant source of revenue considering its contribution to the share of national income, its potential has not been exploited in Uganda as there are still gaps that need to be filled – especially when it comes to registration and formalization.
Some of the government’s stringent measures are still frustrating small businesses. Therefore, encouraging tax compliance demands not only lowers costs but also strengthens the potential benefits of formalization from increased security to new economic opportunities.
The most straightforward administrative strategy for improving informal sector taxation is to reorganize tax administration and strengthen monitoring to provide a more focused incentive for administrators to target small firms and build digital financial literacy for the informal sector.
This article was first published by GlobalDev as part of series organized in partnership with CERDI, UCA, FERDI, and the conference team at GDN.