# **1. Introduction**

This paper measures the impacts of a tax reform directed at Georgian micro and small enterprises (MSEs). Using a panel of administrative data provided by the Revenue Service and regression discontinuity analysis, we examine how the introduction of preferential tax regimes for micro and small businesses in 2010 affects formal firm creation and tax compliance.

Extensive informality of small firms and individual entrepreneurs is frequently cited as a critical challenge for developing countries (Perry et al. 2007, Enste and Schneider 2002). Yet, when looking at the loosely defined concept of informality<sup>2</sup> from a tax policy vantage point, the need for nuance becomes obvious (Keen 2013). Broadly speaking, while small unregistered businesses have little to do with large tax evaders, unreported business activity is ‘informal’ regardless of its initiator. Formality may, however, only be marginally relevant for (micro) businesses with little growth potential; and tax administrations tend not to gain much from paying attention to these entities either. Alternatively, informality may be a smart choice of entrepreneurs gaining cost advantages distorting competition (Farrel 2004) and, in this context, provides a major loophole affecting revenue collections.

Many country-specific factors play a role in determining the scale and scope of informal economic activity, which includes a variety of non-compliant behaviors.<sup>3</sup> Among these, regulatory and tax policy and resulting administrative procedures, are commonly seen as one of the main policy levers. Starting with de Soto’s influential work (1989), many recent studies examining businesses’ formalization decision highlight that unevenly enforced and burdensome regulations as well as corruption (Friedman et al, 2000) and entry costs (Djankov et al., 2002; Auriol and Walters 2005; Bruhn 2013) are associated with (in)formal economic behavior. Looking more specifically at tax regulation, changes in statutory rates combined with enforcement (Ihrig and Moe 2004), sector specific needs for access to formal sources of financing (Feltenstein and Shamloo 2013), as well as regressive compliance costs may determine businesses’ compliance levels (WB 2011).

Consequently, tax policy and administration is likely an important instrument affecting businesses’ formalization decisions and their related growth potential, as well as the development of a reciprocal relationship between governments and the majority of their constituents, particularly in developing economies (IMF 2011, OECD 2010, WBG 2008). A wide range of countries is therefore relying on some form of special tax regimes geared towards small businesses. The benefits and shortcomings of

> 2 Perry et al. (2007, p.21-22) provide a useful overview on the range of agents that can be captured under the term informality. In the context of this paper a definition of “firms and individuals avoiding taxation or other mandated regulations (...) [or] registering only part of their workers and part of their sales” seems most appropriate. When we assess the effect of the Georgian reforms on registration we consider a firm to be registered only when it has also filed a tax return in a given year (non-registered businesses thus includes firms that are registered with the tax authority, but do not file a tax declaration, even if they do not owe taxes).

> 3 Informality and formality are not “all-or-nothing” stages but multi-dimensional with varying degrees. Some firms are registered but do not pay (all) taxes, did not obtain a land title for their premises, or do not have the licenses required for their business. Others may be fully compliant with corporate taxation, but never declare all staff in order to avoid social security contributions. Given its heterogeneous nature, it is clear that there are a multitude of definitions for informal economic activity, possibly affecting measurements of informality (Schneider and Enste, 2000) and often resulting in differing policy recommendations.

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