associated with differentiated tax treatment for MSEs might be overstated; with our findings suggesting that good policy design and administration can be effective in curbing abuses.

The paper proceeds as follows, Section 2 provides an overview on the Georgian tax reform, including a discussion on potential trade-offs resulting from the policy changes. In the following sections we present our data (3), empirical approach (4), and findings (5). Section 6 concludes.

# **2. The 2010 Tax reform for MSMEs**

The Government of Georgia (GoG) passed a new tax code on September 17<sup>th</sup> , 2010 and subsequently conducted several outreach events to inform the private sector of the coming changes.<sup>8</sup> As part of the reforms new tax regimes were introduced for micro and small businesses. The GoG took the established VAT exemption threshold of GEL 100,000 as the starting point for the design of the presumptive (income) tax regime.<sup>9</sup> Businesses with an annual turnover below GEL 30,000 (US$ 18,255<sup>10</sup> ) and without employees were designated as “micro” businesses and exempt from income taxation, and businesses with an annual turnover between GEL 30,000 and GEL 100,000 (US$ 60,850) were designated as “small” businesses and have the option to be taxed based on turnover at a rate of 3 or 5 percent.<sup>11</sup> The design of the Georgian system deviates from commonly used presumptive regimes (i.) by fully exempting micro businesses (instead of requiring a lump sum payment)<sup>12</sup> and (ii.) by offering the option to small businesses to reduce the applicable turnover rate from 5% to 3%, in case of sufficient documented expenditures.<sup>13</sup> This new regime was designed to significantly reduce compliance and administrative costs for businesses and the revenue service. The policy objective of these measures was to foster a culture of compliance and to provide businesses with certainty through registration, particularly for micro entities. Policy makers recognized that actual tax liabilities of small businesses could also be reduced under the new regime, depending on profitability levels. The new tax code came into force retroactively for the tax year 2010.

# _2.1 Background of the reform_

8 See for example: Georgian Journal, 23rd September 2010: “New Tax Code Favors Small Business”; Finchannel September 21st: “IFC, Georgian Ministry of Finance Host Public-Private Dialogue to Reform Tax System; 24 Hours (Daily Georgian Newspaper), 17th September: “Consultation on New Tax Code Finished”.

9 This approach is based on the assumption that taxpayers, who are required and capable to comply with the standard VAT, can also be expected to pay taxes based on their income.

10 Using the August 2012 exchange rate of 1 GEL = 0.6085 USD.

11 The small business tax regime also applies to businesses with annual turnover below GEL 30,000 that have employees.

12 As an additional safeguard, only physical persons that operate a business without employees are eligible for the “micro” status.

13 The regime provides a number of key advantages over a system simply based on gross turnover, most importantly by providing an incentive for performing basic accounting and maintaining a single rate while recognizing differences in sector profitability. At the same time, the approach favors businesses with high profit margins (for instance in the service sector). Finally, the full exemption of micro businesses, using a comparatively high threshold of GEL 30,000, risks creating a strong disincentive to business growth.

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