metadata: authors: 0: author: Coolidge,Jacqueline
1: author: Ilic,Domagoj
count: Southern Africa
docna: 0: docna: Tax compliance perceptions and formalization
            of small businesses in south Africa
docty: Policy Research Working Paper
subtopic: Public Finance Decentralization and
            Poverty Reduction,Tax Administration,Tax Law,Public Sector Economics,Textiles, Apparel & Leather Industry,Construction Industry,Common Carriers Industry,Food & Beverage Industry,Plastics & Rubber Industry,General Manufacturing,Business Cycles and Stabilization Policies,Pulp & Paper Industry,Economic Adjustment and Lending,Taxation & Subsidies,Macro-Fiscal Policy,Food Security,International Trade and Trade Rules
teratopic: Law and Development,International Economics and Trade,Public Sector Development,Industry,Macroeconomics and Economic Growth,Agriculture
abstracts: cdata!: This paper is based on large-scale
            surveys of formal and informal small businesses in South
            Africa, including questions about their experiences and
            perceptions about tax compliance, tax morale, and related
            variables. The survey findings suggest that formalization is
            more likely to take place in urban areas, involving
            relatively larger firms, and those who already use proper
            bookkeeping. Informal firms who said they were likely to
            register for tax in the near future were more likely than
            other informal firms to report higher satisfaction with
            government services, and to believe most businesses pay
            their taxes. The most-cited advantages of being registered
            for tax included better access to government services,
            better access to financing, and better opportunities for growth.
repnme: repnme: Tax compliance perceptions and
            formalization of small businesses in south Africa
display_title: Tax compliance perceptions and
            formalization of small businesses in south Africa
listing_relative_url: /research/2009/07/10805982/tax-compliance-perceptions-formalization-small-businesses-south-africa
topicv3: Agriculture and Food Security m1326205 435,Manufacturing Sectors m1326521 1281,Trade m1326924 698,Tax and Revenue Policy and Administration
            m1327008 720,Taxation m1327615 1121
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Law and Development,International Economics and Trade,Public Sector Development,Industry,Macroeconomics and Economic Growth,Agriculture
no_of_pages: 42
author_keys: 0: author_key: 96589
1: author_key: 670787
model_extractions: WPS4992 Policy Research Working Paper 4992 Tax Compliance Perceptions and Formalization of Small Businesses in South Africa _Jacqueline Coolidge Domagoj Ilic_ The World Bank Investment Climate Department Regulatory Simplification Unit July 2009
Policy Research Working Paper 4992

# **Abstract**

This paper is based on large-scale surveys of formal and informal small businesses in South Africa, including questions about their experiences and perceptions about tax compliance, tax morale, and related variables. The survey findings suggest that formalization is more likely to take place in urban areas, involving relatively larger firms, and those who already use proper bookkeeping. Informal firms who said they were likely to register for tax in the near future were more likely than other informal firms to report higher satisfaction with government services, and to believe most businesses pay their taxes. The most-cited advantages of being registered for tax included better access to government services, better access to financing, and better opportunities for growth.

This paper—a product of the Regulatory Simplification Unit, Investment Climate Department—is part of a larger effort in the department to reduce unnecessary tax compliance costs on businesses. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at jcoolidge@worldbank.org _The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Tax Compliance Perceptions and Formalization of Small Businesses in South Africa**

Jacqueline Coolidge and Domagoj Ilic*

* J. Coolidge (corresponding author, jcoolidge@worldbank.org) and D. Ilic are consultants with the World Bank

We thank the National Treasury of South Africa and the South Africa Revenue Service for initiating this research. Thanks to the Foreign Investment Advisory Service (FIAS, a multi-donor facility of the World Bank Group), USAID, and the Government of Switzerland for financial support. Thanks to Citizen Survey and Professor Rajen Govender for the survey work and preliminary analysis. Thanks to Richard Bird and Michael Engelschalk for peer review. The opinions expressed here do not necessarily reflect those of the World Bank, its Executive Directors or member countries. All errors are our own.
# **Tax Compliance Perceptions and Formalization of Small Businesses in South Africa**

# **Introduction**

**Background and motivation** : The Government of South Africa is committed to encouraging the growth of entrepreneurship in the country, including the formalization of informal firms. To this end, the National Treasury (NT) and the South Africa Revenue Service (SARS) have been developing tax policy and tax administration reforms, including a “tax amnesty” for many previous informal firms and a concerted effort to reduce the tax compliance burden on Small, Medium, and Micro Enterprises (SMMEs).<sup>1</sup> For the purposes of this study, and in line with current tax legislation in South Africa, SMMEs are defined as those with an annual turnover under R 14 million (about US$ 2 million).

At the request of the National Treasury of South Africa (NT) and the South Africa Revenue Service (SARS) in 2006, the Foreign Investment Advisory Service of the World Bank Group (FIAS) initiated a set of surveys to measure the tax compliance burden for SMMEs. Earlier studies in South Africa (e.g., SBP 2005) had also documented onerous compliance burdens on SMMEs, including tax compliance costs in particular.

Anecdotal evidence in South Africa suggested that many of the smallest firms struggle with tax compliance, as is common elsewhere in the world (see Literature Review, below). Meanwhile, fear of “making mistakes” on taxes and the risk of heavy penalties imposed by SARS (in addition to unwillingness to pay taxes) was said to be a factor deterring formalization of many informal firms. Other research in South Africa suggested that broader attitudes about the fairness of the fiscal system (both spending and taxation) and the quality of public services also had an influence on the willingness of the owners of informal firms to formalize and start paying taxes (Fjeldstein, 2004).

**Brief Overview of the Survey** :  To document the extent of the problem in South Africa, FIAS worked with NT and SARS to design a set of three surveys:

- A survey of professional tax practitioners (TP) about their SMME clients

- A survey of SMMEs registered with SARS

- A survey of informal SMMEs regarding their perceptions of tax compliance costs.

The latter two surveys listed above were both co-financed by USAID and carried out by Citizen Surveys. The surveys focused on firms with turnover between R70,000 and R 14 million to exclude both the tiniest “survivalist” firms (e.g., those whose income would be too low to be assessed for personal income tax if they were employees) as well are large firms. The survey field work for the informality survey included 1,000 small businesses that were not registered with SARS (based on area sampling) and took place in mid 2007. The survey of formal firms included 1,000 businesses as a representative sample drawn from the SARS database of registered business taxpayers and was completed in late 2007. Both reports were finalized in March 2008 (USAID, 2008).

> 1 For details of the new tax regime for micro-enterprises (i.e., those under R 1 million turnover), see <u>http://www.sars.gov.za./home.asp?pid=43122</u>

2
**Research Goals:** NT and SARS asked FIAS to make use of the survey data to answer a number of questions about the formalization of informal firms, including the following (for details about analytical methods, see Annex 1):

- What are the characteristics of the 12% of formal firms who reported they had operated for some time before registering with SARS?

- What are the characteristics of the informal firms who reported they are considering registering with SARS?

- Is there a “bridge” that can be found between informal and formal firms?

- What do informal firms know about their tax obligations?

- What are some of the key attitudes of informal firms that may be related to their decisions about formalizing and registering with SARS?

The structure of this paper is as follows. After this introduction, Part 1 provides a summary of the relevant international tax compliance research; Part 2 describes the main survey findings and Part 3 contains conclusions and policy implications.

# **1.  Literature Review**

The original assumptions about tax compliance were rooted in standard analyses of maximization of expected income, taking into account the risks and penalties associated with non-compliance (Allingham and Sandmo, 1972).However, empirical data quickly revealed that taxpayers throughout the world paid much more tax than could be accounted for even by the highest feasible levels of auditing, penalties and risk-aversion. The question therefore switched from “why do taxpayers evade” to “why do taxpayers comply?” (Alm, et al..1992, 2003).

The more recent literature on tax compliance has taken into account economic theory, experimental design, and survey results. While much of the analysis has focused on individual taxpayers, the behavior of business taxpayers (including the self-employed and small business owners as well as managers of joint-stock companies) should probably be similar, and if anything the “elasticity” of tax compliance to the tax burden for business taxpayers should be probably higher than for individuals. Capital has long been documented as the most mobile among the main factors of production. Thus, Tiebout (1956) pointed out that taxpayers can “vote with their feet” by migrating between different jurisdictions, so governments throughout the world must take note that much investment can be “footloose” and that overly heavy tax burdens can deter investment – either encouraging it to search for locations that offer the highest expected after-tax rate of return or discouraging entrepreneurship in favor of wage labor. See also OECD Guidance Note on Tax Compliance (2004).

The OECD (2001) describes the use of surveys to gather evidence on tax compliance, and points out that their strengths include “their ability to capture a broad range of explanatory variables known only to taxpayers, notably their understanding of compliance requirements, relevant values and attitudes, expectations of risks and benefits of non-compliance ... [while disadvantages include] variations in definitions of issues such as non compliance, the integrity of the answers for deliberate or inadvertent reasons, and the inability to report on inadvertent omissions.” 3
Most importantly, Alm et al. stressed that “individuals exhibit much diversity in their behaviour.” Some are primarily worried about getting caught and penalized; others (especially businesspeople who face competition) are more concerned about the behavior of other taxpayers/neighbors/competitors; others think in terms of civic duty and/or public services and may weigh those considerations against the perceived accountability and efficiency of the state. These different factors are all likely to vary across different countries, institutions, and cultures, and much information about such factors can be estimated from surveys.

Alm et al. also found that “tax revenues increase with greater enforcement efforts, but this payoff declines as the probability [i.e., of being caught and punished for tax evasion] increases.” They later note that “compliance increases with [indicators of the availability of public goods and services], and suggest that government can increase compliance by providing goods that their citizens prefer more, by providing these goods in a more efficient manner, or by more effectively emphasizing that taxes are necessary for receipt of government services.” Tax compliance can also have important spillover benefits to firms. The literature on tax compliance notes that one indirect benefit of tax compliance is the discipline imposed on small businesses to prepare and maintain accurate financial accounts (e.g., income statement, balance sheet). Sandford (1995) noted many of the relevant benefits (particularly improvements in information systems and financial control) and these have been further documented by the tax compliance cost literature.

Cummings et al (2004) used both survey-based evidence and experimental results in the U.S., South Africa and Botswana and concluded that tax morale and tax compliance levels appear to be influenced by “the fairness of tax administration, the perceived fiscal exchange, and the overall attitude towards the respective governments.” Alm and Torgler (2006) analyzed tax morale and correlations with cultural differences in the U.S. and Europe. There is strong evidence that tax morale differs across countries, with relatively higher tax morale in the U.S., Austria and Switzerland and relatively lower tax morale in Spain, Portugal and Belgium. They also found strong negative correlation between the size of the “shadow economy” and the degree of tax morale<sup>2</sup> . Higher “tax morale”, in turn, is correlated with various estimates of tax compliance<sup>3</sup> .

In South Africa, Fjeldstad analyzed compliance with local “service charges” (user fees that bear some similarity to taxes) using survey data, and found that failure to comply with service charges (which displayed high degrees of variation both within communities and between communities

> 2 “Tax morale” was measured by responses to survey questions from the World Values Survey: “Please tell me for each of the following statements whether you think it can always be justified, never be justified, or something in between: ... Cheating on tax if you have the chance.”  The size of the shadow economy is measured as a percent of official GDP, using the estimates of the shadow economy from Schneider and Klinglmair (2003) based largely on currency demand.

> 3 Although Alm, Lewis and others have noted that “tax evasion is notoriously difficult to measure”. For example, Alm and Martinez-Vazquez note “A major difficulty in analyzing evasion is its measurement” and in turn cite Tanzi (1980) and Schneider and Enste (2000) “for discussion and applications of various approaches to measurement, all of which are subject to much imprecision and controversy.” Lewis says “Methods of assessing the extent of tax evasion have been indirect and open to a great deal of error.” He goes on to cite Gutman’s methods, (later elaborated by Schneider), using cash demand as a proportion of the money supply as a proxy variable for evasion. However, in the 21<sup>st</sup> century, the growing use of electronic finance has also opened up many new opportunities for tax evasion.

4
with similar socio-economic characteristics) was associated not only with “ability to pay” but also strongly correlated with the following three variables:

- (1) Trust in the local government to use revenues to provide expected services

- (2) Trust in the authorities to establish fair procedures for revenue collection and distribution of services

- (3) Trust in other citizens to pay their share.

# **2.  Main Survey Findings**

Overall 12% of formal businesses reported operating at least for a while before registering for tax. When informal businesses were asked how likely it is for them to register for tax in the next two years 66% of valid responses suggest that it is at least to some extent likely<sup>4</sup> .

Figures 1 and 2 below focus on the data by province. It appears that businesses in Gauteng and Western Cape are the ones most oriented toward the formal sector: Almost 80 % of informal firms in Gauteng report they are at least somewhat likely to register for tax, while only 5% of formal businesses reported they had ever operated informally before registering for tax. By contrast, in Kwazulu Natal (which, like the previous two mentioned, is a relatively urbanized province), only 56% of informal businesses say they are likely to register for tax and 15% of formal businesses reported they had operated informally before registering for tax. Western Cape has low number of formal SMMEs who reported operating informally, but roughly an “average” proportion of informal firms reporting likelihood to register for tax. In the less urbanized provinces (“Other”), 20% of formal businesses reported operating informally before registering.5

**Figure 1: Likelihood for registering for tax by province**

**Figure 2: Operated before registering for tax by province**

<!-- Start of picture text --> 44 85<br> Kw aZulu Natal 56 Kw aZulu Natal 15<br> Western Cape 34 66 Western Cape 10 90<br>79<br> Gauteng 21 Gauteng 5 95<br>63<br>Others 37 Others 80<br>20<br>66<br>Total 34 Total 88<br>12<br>0 20 40 60 80 100<br>Percentage of informal businesses likely or not likely to register for tax in the next 2 0 20 40 60 80 100<br>years Percentage of formal businesses (not) operating before registering<br>Not likely/Neutral Likely Operated before registering for tax Did not operate before registering for tax<br>Province<br>Province<br><!-- End of picture text -->

> 4 The number of non-valid responses is 84 and they mostly refer to answer ‘I don’t know’. If we include these answers, the share of respondents claiming that it is at least to some extent likely that they will register for tax in the next 2 years is 60.3%.

> 5 Survey data was not conducive to a strict urban/rural analysis.

5
Figures 3 and 4 below provide a picture of the sector breakdown. Among informal businesses, those in Agriculture, construction and manufacturing report the highest likelihood to register for tax. Similarly, among formal firms, respondents in these sectors reported a relatively higher proportion that had operated informally before registering for tax (for more on this “bridge” see below).

**Figure 3: Likelihood for registering for tax by sector**

**Figure 4: Operated before registering for tax by sector**

<!-- Start of picture text --> 62 89<br>Services Services<br>38 11<br>Trade 34 66 Trade 13 87<br>construction,Agriculture, 78 Agriculture, mining, 86<br>manufacturing 22 forestry, construction,manufacturing 14<br>66<br>Total 34 Total 88<br>12<br>0 20 40 60 80 100<br>Percentage of informal businesses likely or not likely to register for tax in the next 2 0 20 40 60 80 100<br>years Percentage of formal businesses (not) operating before registering<br>Not likely/Neutral Likely Operated before registering for tax Did not operate before registering for tax<br>Sector<br>Sector<br><!-- End of picture text --> Figures 5 and 6 focus on employment. As might be expected, among informal businesses, those with more employees are relatively more likely to report a possibility for registering for tax. Among formal businesses, those with with over 30 employees were the least likely to reported they had ever operated informally.

**Figure 5: Likelihood for registering for tax by number of employees**

<!-- Start of picture text --> 75<br>25<br>71<br>29<br>66<br>34<br>61<br>39<br>61<br>39<br>66<br>34<br><!-- End of picture text -->

**Figure 6: Operated before registering for tax by number of employees**

<!-- Start of picture text --> 93<br>7<br>93<br>7<br>87<br>13<br>86<br>14<br>86<br>14<br>89<br>11<br>88<br>12<br><!-- End of picture text --> 6
# **Informal – formal “bridge”**

To investigate the possible “bridge” (i.e., regular similarities that could be found in the survey data) between the informal and formal companies we undertook an analysis focusing on two specific samples in both surveys. These samples represent those formal businesses who reported they had been operating for a while before formalizing, and those informal businesses who reported likelihood for formalization within the next two years. A note should be made that the two surveys used different methodologies<sup>6</sup> , and that sometimes makes the comparison rather difficult.

The analysis that follows will try to investigate what kinds of businesses tend to be more frequently part of this “bridge” between formal and informal.

# **Sector**

Due to different methodologies and different structures of the formal and informal economies, the sector structure of two samples (formal and informal businesses) is not comparable without some regrouping of categories. In order to compare these samples three broad sectors were newly established:

- Agriculture, forestry, fishing, mining, construction and manufacturing

- Trade

- Other Services

# **Figure 7: Operating before registering (for formal businesses) and likelihood of registering (for informal businesses)**

<!-- Start of picture text --> 88<br>89<br>87<br>86<br>12<br>11<br>13<br>14<br>66<br>62<br>66<br>78<br>34<br>38<br>34<br>22 Percentage of businesses<br><!-- End of picture text -->

> 6 Formal survey was done using telephone interviewing as a data collection method while informal survey was done “face – to – face”. The formal survey was based on a

> representative sample  of SMMEs registered with SARS while the informal survey used area based sampling.

7
Additional Chi square tests showed no statistically significant differences between sectors in the formal sample, but statistically significant differences do appear to exist among the informal businesses<sup>7</sup> . The analysis of this significant difference in the informal sample and a tendency in the formal one shows that businesses in agriculture, mining, forestry, fishing, construction and manufacturing tend to be more frequently a part of the bridge between the formal and the informal economy, while service sector businesses (other than trade) tend to be a part of this bridge less frequently, and trade is in the middle.

In other words, informal firms in primary industries and manufacturing more frequently report they are likely to formalize and conversely, are the same sectors among formal firms that are most likely to have operated for a period of time informally. In contrast, informal firms in the service sector report they are relatively more likely to stay in the informal sector, while formal firms in the service sector are more likely to have started out formal (i.e., registered for tax) to begin with. Unfortunately the survey categories do not allow for further disaggregation.

# **Size**

The T-test shows that the difference in the number of workers among informal businesses likely to register and those not likely to register is significant8 and that the likelihood for tax registration is higher if the business employs more workers. The same can be seen when looking at Figure 8. This may be due to the difficulties of “hiding” relatively larger firms from the tax authorities.

# **Figure 8: Informal business size and likelihood for tax registration**

<!-- Start of picture text --> More than 6 75<br>4 - 6 71<br>3 66<br>2 61<br>1 61<br>Total 66<br>50 55 60 65 70 75 80<br>Percentage of informal businesses likely to register<br><!-- End of picture text --> 7 Chi square = 12.713, significant on 1% level 8 T = 4.052, significant on 1% level 8
# **Registration with Government Agencies and Business Associations**

As Figure 9 clearly suggests, businesses that are already registered at some government agency or professional association (the national business registry - CIPRO, Chamber of Commerce, Business associations, Workers Compensation and other) are more likely to make the next step and register for tax<sup>9</sup> .

# **Figure 9: Registered at government agency or professional association and likelihood for tax registration**

<!-- Start of picture text --> Business not<br>62<br>registered anyw here<br>Business registered at<br>75<br>least somew here<br>Total 66<br>50 55 60 65 70 75 80<br>Percentage of informal businesses likely to register<br><!-- End of picture text --> 9 Chi square = 13.034, significant on 1% level 9
# **Location of business operation and value of assets**

It seems that business owners who are renting their business premises are more likely to consider tax formalization (See Figure 10)<sup>10</sup> . They may be at highest risk from their landlords declaring their rental income and thereby being discovered by SARS. Landlords may also want to see tax clearance certificates as part of their credit clearance. The value of assets does not seem to significantly influence the likelihood for registering for tax (t-test does not result in a statistically significant difference), and as Figure 11 suggests, it seems to be the lowest among businesses with the lowest value of assets.<sup>11</sup>

**Figure 10: Location of business operation and likelihood for tax registration**

**Figure 11: Value of assets and likelihood for tax registration**

<!-- Start of picture text --> Place of business 59 More than 200K Rand 64<br>changes<br>71K - 200K Rand 67<br>Separate premises - 74<br>rented<br>31K - 70K Rand 68<br>Separate premises - 65<br>ow ned<br>11K - 30K Rand 72<br>Same premises 62<br>w here you live 10K Rand or less 55<br>Total 66 Total 66<br>50 55 60 65 70 75 80 50 55 60 65 70 75<br>Percentage of informal businesses likely to register Percentage of informal businesses likely to register<br>Value of assets<br>Place of business operation<br><!-- End of picture text -->

# **Customers’ method of payment**

As expected, the survey data supports the supposition that cash payments from customers have a negative influence on likelihood for tax registration. Businesses reporting using only cash payments tend to report that they are likely to register less frequently than those paid with other methods<sup>12</sup> .

**Figure 12: Payment method and likelihood for tax registration**

<!-- Start of picture text --> At least some 72<br>account<br> Cash only 64<br>Total 66<br>50 55 60 65 70 75<br>Percentage of informal businesses likely to register<br>Customers paying method<br><!-- End of picture text --> 10 Chi square = 12.999, significant on 1% level 11 Only visual inspection of the figure suggests this assessment. Statistical tests do not demonstrate statistical significance.

12 Chi square = 5.414, significant on 5% level 10
<!-- Start of picture text --> ~<br><!-- End of picture text -->
**Figure 14: Record keeping practices and likelihood for tax registration by number of employees**

<!-- Start of picture text --> 57<br><!-- End of picture text --> <!-- Start of picture text --> 58<br><!-- End of picture text --> <!-- Start of picture text --> 65<br>66<br><!-- End of picture text --> <!-- Start of picture text --> 70<br><!-- End of picture text --> Additional testing showed that there is a significant difference in the likelihood for registration between record keeping and non-record keeping businesses, but only for the two smallest categories<sup>14</sup> (with 1 and 2 employees). This analysis supports a conclusion that bookkeeping practices have an independent, positive influence on the likelihood for registration, at least among the smallest businesses.

> 14 For businesses with 1 employee -  Chi square = 6.546,  significant on 5% level; for businesses with 2 employees -  Chi square = 4.321, significant on 5% level

12
# **Knowledge about nearest SARS office and its distance**

Informal businesses reporting that they know where the nearest SARS office is are more likely to register for tax than other respondents<sup>15</sup> . Also, although statistical tests are not significant at the 5% level<sup>16</sup> , it seems that the distance to the nearest SARS office (comparing those reporting they are less than 30 minutes versus more than 30 minutes away) has some influence on the likelihood of registration. If so, these findings may suggest there is merit in ensuring an adequate “field presence” of tax offices – either to provide wider outreach of services or to increase the (perceived) probability of discovering informal businesses.

**Figure 15: Awareness of the nearest SARS office and its distance and likelihood for tax registration**

<!-- Start of picture text --> 57<br>67<br>75<br>66<br><!-- End of picture text -->

> 15 Chi square = 13.125, significant on 1% level

> 16 Chi square = 3.483, significant on 7% level

13
# ~~aT~~
# **Attitude: Everybody should/does pay taxes**

Respondents believing that all businesses should pay taxes and that most of them actually do (this category is combined from two statements about should everybody pay tax and if they actually do) are much more likely to register for tax, and the difference is highly significant.<sup>19</sup>

# **Attitude: Information about registration is available**

It seems that attitude towards availability of information about tax registration and knowledge about it does not significantly influence the likelihood of registering for tax. (The level of significance is 10.4%)

# **Figure 18: Attitude: “Everybody should (and does) pay taxes” and likelihood for tax registration**

# **Figure 19: Attitude: “Information about registration is available” and likelihood for tax registration**

<!-- Start of picture text --> Agree 77 Agree 69<br>Disagree 54 Disagree 63<br>Total 66 Total 65<br>50 55 60 65 70 75 80 50 55 60 65 70<br>Percentage of informal businesses likely to register Percentage of informal businesses likely to register<br>Attitude: Everybody should (and do) pay taxes<br>Attitude: Information about registration is available<br><!-- End of picture text -->

# **Attitude: Tax authority/officers are unfair / corrupt**

Chi square analysis did not find the difference outlined in Figure 20 as significant at the 5% level of risk (the level of calculated risk is about 7%), but it still seems that there is at least a tendency showing that the belief that tax authority officers are unfair or corrupt may influence one’s decision to register for tax.

# **Figure 20: Attitude: “Tax authority/officers are unfair / corrupt” and likelihood for tax registration**

The survey of registered SMMEs did not include a similar question. It was excluded based on previous surveys which found little evidence of corruption in tax administration in South Africa (SBP, op cite).<sup>20</sup> <!-- Start of picture text --> Agree 61<br>Disagree 68<br>Total 64<br>50 55 60 65 70<br>Percentage of informal businesses likely to register<br><!-- End of picture text -->

> 19 Chi square = 42.657, significant on 1% level; correlation between the two variables is 0.291.

20 See also Transparency International, where South Africa is ranked second-best in Africa (after Botswana) and on par with South Korea.

15
# **Problems / issues and likelihood of formalization**

An analysis was done on 14 different issues<sup>21</sup> on which respondents were asked to report whether a certain issue is an obstacle for their business operation and growth, and their relationship to the reported likelihood for registering for tax. It was reasonable to expect that respondents who reported having problems associated with “Not being registered for income tax”, “Not being registered for VAT” and “Not being registered for UIF” would in fact be more likely to report likelihood to register for such taxes in the near future. As one would expect, the differences were highly significant in differentiating respondents who reported they were likely to register from those not,<sup>22</sup> but such answers are not very useful in terms of policy implications.

Most other issues showed themselves not to be very significant drivers for such a decision, so for these other issues, a more flexible significance rate of 10% will be used as a criterion to try to figure out which ones may have an influence on the likelihood for registration.

It is not surprising that respondents feeling they have to hide from the authorities to avoid paying tax consider registration more frequently23 than those not having this problem (Figure 21), but it is interesting that:

- Respondents considering labor regulations to be a problem are relatively more likely to consider registration for tax.24

- 25 26

- • Respondents perceiving access and cost of financing as a problem are more likely to consider registering for tax (see also Gatti and Honoratti, 2008).

- 27

- • Respondents citing transportation as a problem for their business are less likely to consider registration for tax than other firms.

> 21 The issue mentioned here are covered in question 16 of the informal questionnaire

> 22 Chi squares of 13.104, 16.696 and 14.723 respectively significant on 1% level

> 23 Chi square = 6.469, significant on 2% level

> 24 Chi square = 3.319, significant on 7% level and correlated with number of employees.

> 25 Chi square = 5.085, significant on 5% level

> 26 Chi square = 3.347, significant on 7% level

> 27 Chi square = 5.960, significant on 2% level

16
# **Figure 21: Issues / problems and likelihood for tax registration**

Additional analysis was performed to see if the number of problematic issues and their severity, as reported by respondents, have an influence on their likelihood for tax registration. For the analysis of the influence that the “number of perceived problems” may have on their “likelihood for registration,” respondents were divided into two groups: those considering more than half of the issues as “problematic” and those considering half or less of the issues as “problematic.” The analysis showed no difference between these two groups when likelihood for registering is concerned.

However, an analysis resulting in a more interesting finding can be found when we examine the share of issues perceived to be a “major problem.” This analysis shows that respondents reporting more than half of the issues to be a “major problem” consider registering for tax significantly less <u>often</u> than other businesses (Figure 22)<sup>28</sup> .

> 28 Chi square = 5.960, significant on 2% level

17
**Figure 23: Issues perceived as “major problems” and likelihood for tax registration**

<!-- Start of picture text --> 50<br>51<br>54<br>54<br>55<br>59<br>66<br><!-- End of picture text --> The findings outlined in Figure 23 are in accordance with the findings in the analysis of various attitudes about government services. If businesses feel that government is providing good service for taxes paid and see the benefits of registration, then they are more likely to register. However, when businesses do not see services provided, then the likelihood for formalization is lower.

In order to investigate more deeply, additional analysis was done comparing respondents reporting major problems with these issues and those not, and their respective attitudes towards government returns for taxes paid (Attitude: “Government gives a good return for taxes paid”). This analysis confirms that respondents reporting major problems with infrastructure and government services have a significantly lower attitude about the “returns” that businesses get from the government for taxes paid (see annex 3). Such firms, in turn, are relatively less likely to report they are considering registering for tax in the near future.

19
# **Figure 25: Perceived advantages of registration and likelihood for registration**

<!-- Start of picture text --> Helping the poor / community / country 66<br>Tax refunds 69<br>Being legal 73<br>Better access to government services 74<br>Better opportunities / situation for my business /<br>72<br>growth<br>Access to and price of financing 73<br>Total 66<br>Other 56<br>Don't know 54<br>No advantages 51<br>40 45 50 55 60 65 70 75 80<br>Percentage of informal businesses likely to register<br>Advantages of registering for taxes<br><!-- End of picture text --> Perceived disadvantages of registering for tax are presented in figure 26. As expected, the largest category of respondents cited the financial burden of taxation.<sup>35</sup>

**Figure 26: Perceived disadvantages of registration for tax**

<!-- Start of picture text --> 0 10 20 30 40 50<br>Tax too high / higher financial burden 32<br>Worse business situation / less opportunities 27<br>Gov't not giving services / mishandling money /<br>27<br>corruption<br>Fear of prosecution 19<br>Complicated / expensive / risky tax compliance 14<br>Other 13<br>No disadvantages 9<br>Don't know 11<br>Percentage of respondents<br>Perceived disadvantages of registering<br><!-- End of picture text --> 35 Analysis of the size of tax payments was outside the scope of the survey, but could be undertaken on the basis of SARS’ data for formal micro-enterprises. However, international survey data shows that complaints about tax burdens are nearly universal across countries and are not necessarily significantly correlated with actual tax burdens (World Bank, 2004, pg. 13).

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A comparison of perceived disadvantages and the likelihood for registration again leads to the conclusion that respondents who do not perceive that they get a positive return for taxes paid and that government is not providing enough services are relatively less likely to register. With that, respondents perceiving that registration would lead to high compliance burden also have lower likelihood for registration than average.<sup>36</sup> As one might expect, the highest likelihood for registration is reported by respondents who do not report any disadvantages. It seems that even those who fear prosecution in the event of registration have a higher than average likelihood for registration (or maybe they fear even more being caught as informal). Finally even respondents emphasizing higher financial burden and worse business conditions do not report likelihood for registration that is lower than the overall average.

**Figure 27: Perceived disadvantages of registration and likelihood for registration**

<!-- Start of picture text --> 52<br>59<br>62<br>66<br>68<br>69<br>74<br>74<br>80<br><!-- End of picture text -->

> 36 Note Figure 17 on page 10 refers to a question about the cost of complying with tax which included the burden of the tax obligation itself, while this question focuses more specifically on the “compliance cost” alone.

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# **Perceived share of similar businesses paying all, some or none of the taxes and likelihood for registration**

Although the question of causality makes an interpretation somewhat difficult, it is interesting to see the relation between perception of share of businesses paying taxes (and to what degree) on one side and likelihood for registration on the other side.

**Figure 28: Perceived share of businesses paying taxes and likelihood for registration**

<!-- Start of picture text --> 37 22 41<br>Likely to register<br>Not likely/Neutral to 27 19 54<br>register<br>0% 20% 40% 60% 80%<br>Paying all taxes<br>Percentage of businesses"similar to mine" perceived as Paying some, but evade certain portion<br>Not paying tax at all<br>Likelihood for registration<br><!-- End of picture text --> What figure 28 suggests is that both groups (those reporting they are likely to register for tax and those unlikely/neutral) have a similar perception about the share of businesses paying some of their taxes but evading a certain portion. However when it comes to perception of the share of businesses paying all of their taxes and the share of businesses paying none, their perceptions are quite different. Businesses who report they are likely to register perceive a significantly higher share of businesses paying all the taxes than businesses not likely/neutral to register (37% and 27% respectively)<sup>37</sup> . Correspondingly, business not likely (or neutral) towards registration perceive that a significantly higher share of businesses “similar to” themselves are not paying taxes “at all” than those respondents who reported they were likely to register for tax (54% and 41% respectively)<sup>38</sup> .

> 37 T = 6.475, significant on 1% level

> 38 T = 6.812, significant on 1% level

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# ~~z~~
# **Perceived capability for tax compliance and likelihood for registration**

Also, it seems that businesses reporting they are likely to register for tax feel themselves more capable to bear the tax compliance burden both in terms of necessary skills and expertise as well as the financial burden it carries. Businesses reporting they are likely to register perceive their capacity to handle the compliance burden to be significantly higher than businesses not likely to register in both expertise and skills dimension<sup>40</sup> and cost dimension<sup>41</sup> . These differences are highly significant.

**Figure 30: Perceived capability for taking tax compliance burden and likelihood for registration**

<!-- Start of picture text --> 3.2<br><!-- End of picture text --> <!-- Start of picture text --> 3.2<br><!-- End of picture text -->

> 40 T = 5.058, significant on 1% level

> 41 T = 5.011, significant on 1% level

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# **Knowledge about the location of SARS office and awareness of tax amnesty compared to reported likelihood for registration**

Respondents who are aware of the nearest SARS office are more likely to register for tax than those unaware<sup>42</sup> . Also, it seems that the respondents who were aware of Tax Amnesty were also more likely to say they might register for tax<sup>43</sup> . However it seems that the level of knowledge about details concerning tax amnesty is about the same among respondents likely and unlikely to register.

**Figure 31: Awareness of nearest SARS office and Tax Amnesty and likelihood for registration**

<!-- Start of picture text --> Aw are of Tax amnesty 76<br>Aw are of nearest SARS<br>70<br>office location<br>Total 66<br>50 55 60 65 70 75 80<br>Percentage of informal businesses likely to register<br>Respondents reporting they are ...<br><!-- End of picture text -->

> 42 Chi square = 13.125, significant on 1% level

> 43 Chi square = 29.853, significant on 1% level

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**Perception of percentage of formal and informal businesses suffering negative phenomena imposed by SARS and likelihood for registration**

Figure 32 suggests that, while likelihood for registration does not depend on perception of how frequently tax registered businesses have inspections and audits and suffer penalties and fines, businesses who are likely to register estimate the share of “caught” informal businesses to be higher than businesses not likely to register.<sup>44</sup>

**Figure 32: Perception of negative phenomena Figure 33: Experiencing negative phenomena and likelihood for registration and likelihood for registration**

<!-- Start of picture text --> Percentage of informal businesses likely to register<br>60 65 70<br>...more than 10% of tax registered businesses pay 68<br>penalties and fines to SARS each year<br>Businesses suffering<br>...more than 10% of tax registered businesses are negative experiences to 66<br>subjected to SARS inspections and audits every 69 sustain their informal<br>year status<br>...more than 10% of non registered businesses 74<br>w ere caught by SARS last year<br>Total 66<br>Total 66<br>60 65 70 75<br>Percentage of informal businesses likely to register<br>Respondents believing that...<br>Respondents believing that...<br><!-- End of picture text --> Businesses were asked if they experienced any negative phenomena (i.e. cost) to sustain their informal status, such as:

- Paying bribes to sustain the informal status

- Providing free products or services to sustain the informal status

- Temporarily shutting business down to avoid being detected by SARS

- Relocating the business to avoid being detected by SARS.

The great majority of respondents (94% of them) reported none. When an analysis was done to establish if these negative experiences might trigger the higher chance for registration, results show that there is no significant influence of these negative experiences on likelihood for registration.

> 44 Significant at the 5% level.

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# **3.  Conclusions and Policy Implications**

The surveys of formal SMMEs and informal firms may provide useful information to guide the efforts of the National Treasury and SARS to encourage higher rates of voluntary registration among informal firms. Comparing the two surveys, it was noteworthy that firms in Gauteng province appear most oriented toward formality, with relatively low numbers of formal firms reporting they had ever operated informally before registering for tax and relatively high numbers of informal firms reporting they are likely to register for tax soon. This may suggest that formalization is easier to encourage in relatively urbanized settings.

While almost 90% of formal firms reported they had never operated informally before registering for tax, firms in the primary sector (agriculture, forestry, fishing and mining), construction and manufacturing appear relatively more likely to start out informal and to register themselves at some point. By contrast, firms in trade and other services seem either to start out and stay informal or to initiate operation as a formal company registering for tax at the outset.

As expected, businesses that are not registered for tax, but are registered with CIPRO, Chamber of Commerce, or other business associations, are relatively more likely to report they plan to register for tax. Similarly, informal firms with more employees appear more likely to register for tax.

Interestingly, businesses who rent their premises are relatively more likely to register, probably because they anticipate a higher likelihood of coming to the attention of the authorities because their landlords may report the rental income.

Informal businesses who keep financial records are significantly more likely to report they expect to register for tax, as are those who felt confidence in their abilities to do the necessary accounting and fill out tax forms. Those who knew the location of the nearest SARS office (and within that group, those who are closer to the SARS office) were also more likely to register. Informal firms who are concerned about their access to finance were relatively more likely to report they may register for tax. Conversely (but as expected), informal businesses who receive most of their income in cash report they are less likely to register for tax. Perceptions about SARS inspections and penalties did not appear to make statistically significant differences in the reported likelihood for registration, but a perception that many informal businesses are caught by SARS seemed to be associated with a relatively higher likelihood for registration.

Attitudes toward government and perceptions of problems associated with government appear to have a significant influence on the likelihood of informal firms registering for tax. In particular, respondents who believe that government provides good service for taxes paid are significantly more likely to report that they may register for tax in the near future. Similarly, informal firms who believe that everyone should pay some tax (and who believe that most firms do pay taxes) are more likely to report they may register for tax. These attitudes are much more significant than the respondents’ attitude toward the availability of information about tax registration.

Firms complaining about “major problems” associated with crime, infrastructure (telecoms, transportation and electricity) and “skills and education of available workers” were relatively less likely to register for tax than firms who perceived such issues to be less serious problems. Thus 28
solving or mitigating such problems may reap rewards for the government in the form of higher formalization and tax compliance.

Perceived advantages of registration for tax included “better opportunities for growth”, followed by “being legal”, “helping the poor/community”, “access to financing” and “better access to government services.” Disadvantages, as expected, included the financial burden of taxation, and dissatisfaction about government services. Closer examination of SARS’ data on tax returns from SMMEs may be fruitful to better understand that burden.

# **Policy implications**

The picture of formalization is therefore somewhat complex, with relatively few clear opportunities for SARS to encourage higher rates of voluntary tax registration on the basis of their own behavior or performance. Rather, informal businesses seem most encouraged to register when they view government services as “good value” for taxes paid, when they perceive that most businesses (e.g., their own suppliers, customers, and competitors) are paying taxes, and when they are carrying out basic bookkeeping.

Of course, from the point of view of public finance, there may appear to be a “chicken and egg” problem: formalization could be encouraged by improved government services, but such services must be paid for by revenues. Given the fact that small businesses yield only tiny amounts of revenue under the best of circumstances, it is probably the government side that should move first to target improved services in communities where there appears to be high levels of informality; targeting those services that appear to be of most concern to small businesses (i.e., crime, infrastructure and worker skills). Improved services, in turn could form the basis of a coordinated campaign by the GoSA to showcase improvements in public services wherever possible, and to stress the need for higher levels of compliance to expand/improve services. It may also be worth considering whether resources for local governments to pay for critical services are adequate to encourage higher rates of voluntary tax compliance.

While general trends away from reliance on cash payments for transactions and toward electronic and other bank-mediated forms of payment may over time help to encourage more formalization (and tax compliance more broadly), NT and SARS want to look for ways to encourage those trends. Since likelihood for formalization seems to be associated with the practice of proper bookkeeping, it may also be advantageous for NT and SARS to encourage small businesses to maintain regular books, to learn the basics of bookkeeping, and/or to hire the necessary expertise. It would be beneficial to remind small businesses that proper bookkeeping is important for the financial health of all businesses, and critical for any business that aspires to expand. Another key message should be that tax compliance expands business opportunities to enter the supply chain of larger businesses and to gain improved access to larger and wealthier markets. SARS’ SME office (perhaps working in cooperation with SME Associations) may help expand bookkeeping training for small businesses, especially in conjunction with the new turnover tax, which is designed to be handled by entrepreneurs with limited accounting skills. Working in cooperation with SME associations may be the most effective way to deliver both the training and the “message.” 29