The challenges for taxing SMEsALTax
The enormous conference and meeting around the world in these latest years have looked at a broad range of tax issues that impact microenterprises and SMEs. The way in which the tax system affects SMEs and the compliance issues they create have long been of central importance to both economic policy makers and revenue authorities. Fundamental challenges for taxing smaller enterprises often arise from the need to involve them in withholding payroll taxes and social contributions from their employees.
Simplification in this area is far from easy and may not be advisable, given the (increasing) importance of social insurance schemes for which some record of individual level contributions is necessary.
Economic policy in many countries places an emphasis on SMEs as an important source of employment, innovation and economic growth. Market failures such as adverse selection in lending and information costs (since due diligence costs for potential investors and lenders may be relatively fixed which means investors are often reluctant to do many small deals in preference to one larger one) provide a rationale for policy intervention, which may occur via the tax system.
However, it is hard to distinguish genuine market failure from the market working and weeding out bad deals. Not infrequently, ideas pitched to investors and banks by small businesses and start-ups may have little ultimate commercial potential. However, distinguishing between these ex ante given the uncertainties involved can be very difficult.
This places a premium on the creation of multiple financing channels, such as the promotion of business angel investors for SMEs, which can provide a heterogeneous pool of investors and lenders with different views and knowledge levels about the risks and market prospects in different SME sectors. A SME investment unacceptable to one investor may be seen as a good commercial opportunity by another.
Innovative SMEs can face particular problems accessing finance as they are by definition inherently riskier, and it is harder to secure lending against hard to value and trade intangible assets which may make up most of their asset base, and underpin their enterprise valuation.
Capital or equity gaps are difficult to define and measure because we cannot get at the counterfactual of what state of the world would otherwise have emerged. Structural features such as steeply stepped administrative burdens, e.g. first employee; complexity, resulting in a need to incur professional fees; and the cliff edges of some targeted SME tax incentives, are a mixture of the unavoidable and the inevitable.
Governments that target assistance at SMEs should aim for burdens and complexity to be minimized and proportionate. Experience in some OECD countries such as the UK suggests that even where SME tax reliefs exist, many do not make use of the reliefs available. This is mainly because targeted reliefs may not be relevant but there is also a strong perception that they are difficult to claim with detailed and complex criteria, with the latter generally existing to deal with potential avoidance issues.
Uncertainty as to whether tax claims would succeed is another issue for SMEs.
Finally, lots of SMEs are unaware of the existence of tax and nontax mechanisms for assisting SMEs which raises questions over the effectiveness of the communication strategies toward SMEs used by revenue authorities and ministries, and other bodies responsible for economic development.
Lowering the tax burden on SMEs, both in terms of revenue levied and the compliance costs, is thus often seen as important if this enterprise segment is to thrive. Recognising the diversity of microenterprises and small and medium sized enterprises (MSME) is critical to sensible tax design. A feature of microenterprises and small and medium sized enterprises is their heterogeneity. Within any country, the microenterprises and small and medium sized enterprises sector may include street sellers barely at subsistence level, highly paid professionals, and substantial manufacturing as well as innovative service enterprises; and what one country would see as a small enterprise might in another find itself in the large taxpayer unit.
It is also an important fact in most countries, however, that MSMEs generally contribute far more to output and employment than they do to tax revenue. This fact may be overstated by the widespread use of larger enterprises (and imports) as withholding points illustrating too that MSMEs may be powerfully affected by taxes formally borne by others and reflects choices made in designing and enforcing the tax system. This suggests, nevertheless, some degree of untapped revenue potential and an uneven playing field in many countries.
From a tax authority’s perspective, the often-complex linkages between the different taxes collected and paid by SMEs and the frequent scope for evasion and avoidance need very careful handling. At its worst, poorly designed SME tax policy and tax administration can lead to major leakages in labour and social security tax revenues, via tax motivated incorporation, without much offsetting benefits in terms of enhanced economic growth, employment and productivity amongst the population of SMEs.
This implies that the best response to market failures that may adversely affect MSMEs is often unlikely to be through size related tax measures. Arguments are sometimes made for preferential treatment of smaller enterprises on pure policy grounds: if they have difficulty raising external finance, for example, a reduced tax rate on retained earnings, freeing more internal finance, may seem useful. The importance of this and other possible market imperfections in impeding realisation of the full potential of MSMEs remains unclear.