BUSINESS TAXATION Presumptive Tax: Equalizing distribution of tax burden (II)
resumptive taxation offers two additional benefits to both governments and taxpayers: it allows the government to tax its citizens in a more equitable fashion while rewarding efficient businesses with financial incentives. It is generally accepted that wages and salaries paid by corporations and governments are taxed more effectively than income earned by the self-employed due to the introduction of withholding taxes at source. Simplified presumptive taxation schemes increase the probability that the self-employed are also taxed effectively.
At the same time, many presumptive taxation regimes entice SMEs into the tax net by discarding high tax rates and providing incentives rewarding efficiency. For example, methods such as taxing based on average ratios (profits to sales) and average income allow businesses to retain some profits without being taxed. Moreover, many developmental economists advocate a presumptive tax on the potential use of land (assuming it has been used as productively as possible) to encourage land owners to utilize land productively.
Various methods of estimating income and assessing tax liability have been developed by countries that have employed the presumptive income taxation. Some of these methods include standard assessment, estimated assessment, value of land, net wealth and asset value, visible signs of wealth, and minimum taxes amongst others.
Standard Assessment
Standard assessments assign lump-sum taxes to taxpayers on the basis of occupation or business activity. Standard assessments have been shown to broaden the tax base with limited disincentives. Although this method is viewed as less equitable than estimated assessments, it is also less open to corruption.
In the early 1960s, Ghana introduced a simple standard assessment system that fixed lump-sum payments for different economic activities. The payments were established by determining the average taxable income of a few taxpayers selected at random from each class of self-employed taxpayers.
It is important to understand that standard assessments can be a poor revenue-mobilizing method of taxation unless the fixed payments are indexed to inflation (or increased regularly) and taxpayers are moved to categories as their taxable incomes increase over time. Furthermore, standard assessments do not take taxpayerspecific conditions, such as family size or losses in a particular year into account. As a result, it can be regressive by imposing equal tax on individuals in the same category even when they earn different incomes.
Estimated Assessment
In this assessment method, each taxpayer’s income is individually estimated based on indicators or proxies of wealth specific to a given profession or economic activity. Key indicators can range from location of property to numbers of skilled employees to seating capacity. France’s Forfait and Israel’s Tahshiv methods both utilized estimated assessments and are recognized as among the most highly developed presumptive tax regimes of their time.
Israel’s Tahshiv method employed objective factors to estimate the income of taxpayers unable to keep records. The Tahshiv for each sector was prepared, often over several years, after extensive research and many visits to a sample of businesses. The average profitability of a particular sector and its relationship to specific factors and indexes were discussed with representatives of the sector before the official Tahshiv was issued. Examples of indicators employed included number of employees, location, seating capacity (for restaurants, cafes, barber shops, etc.), skill level of workers (for carpenter’s workshop or garages), nature of equipment used (for truck and taxi drivers), and water consumption (for ice-producing companies).
The estimated assessment method of presumptive taxation employs a variety of techniques to derive taxpayer income, both simple and complex. Simple methods are based on single factors such as a taxpayer’s total assets, net wealth or value of business assets, gross receipts of business, and visible signs of wealth. Complex methods use factors and indices of profitability, which vary by economic activity.
Net Wealth and Asset Value
Factors such as net wealth and value of assets enable income estimation through the comparison of beginning of year with end of year net worth. As one can imagine, it is difficult to determine the amount at the beginning and end of the year with any precision, much less account for expenditures during year. Tax authorities in developing nations such as Argentina, Chile, and Colombia employ this method as a basis for presuming income during audits. However, they are faced with various technical problems when doing so. For example, since it is easy to identify owners of some assets versus others (agricultural land vs. foreign currency) equity issues arise. Moreover, valuation of assets is a problem and presumptions based on net wealth often encourage taxpayers to increase liabilities.
Visible Signs of Wealth
Taxes on visible signs of wealth serve as an equity issue. It serves to ensure that wealthy citizens pay an appropriate amount of tax, even if they report all actual income. The taxes apply only to individuals and usually include main and secondary residences, the number of domestic servants, cars, yachts, private planes and race horses. In European countries such as France, Italy, and Spain (until 1978) signs of wealth qualified and how much income to attach was detailed in income tax ordinances. In practice, this method has proven to be difficult to apply. If the applicable tax law is general, it is hard to know which signs of wealth to choose, and what amount to assign. If the opposite is true, the laws are often inflexible and unfair. As a result, taxes on signs of wealth are applied cautiously and when there are no other means to assess income. They are often helpful in determining income on illegal activity such as racketeering or drug trafficking.
Minimum Taxes
Alternative minimum taxes come in many forms. Some schemes specify a tax burden or minimum tax irrespective of the taxpayer’s level of income or economic activity. Others levy the tax as a relatively low percentage of turnover or assets. Francophone Africa pioneered the establishment of minimum corporate income taxes by introducing fixed lumpsum amounts that were uniform for all corporations regardless of size or volume. Due to its regressive nature, this minimum tax was replaced in many countries by a tax based on a percentage of gross receipts. In countries with both types of minimum taxes, corporations pay the larger of the two. In others, the minimum tax is also applied to individuals. The practice of minimum taxes has spread beyond Africa to become the prevalent form of presumptive taxation in Latin America.
Challenges of Presumptive Taxation
Presumptive Tax Regime is no doubt gaining popularity, especially in developing nations. However, there are challenges and obstacles that tend to compromise its effectiveness. Governments that recognize the limitations of presumptive taxation often times include provisions in their tax codes that allow taxpayers the opportunity for a redress. Listed below are some of the challenges that affect the smooth administration of presumptive taxation.
Crude Implementation
Despite its streamlined requirements, presumptive taxation is not always effective because governments do not have sound tax administration systems in place at the federal, state or local levels to implement schemes as envisioned by policy makers. Countries in early stages of economic development tend to employ crude methods of estimating income because they lack sufficiently qualified resources to analyze the profitability of various economic activities and to define the indexes for effectively calculating presumptive incomes. As a result, small businesses in particular are routinely taxed unfairly and inefficiently.
Systemic Corruption
Arguably, presumptive taxation can help reduce corruption in tax administration. However, the success of presumptive taxation in reducing corruption will depend both on the structure of the scheme and the overall administrative environment and capacity of the tax administration institution. A presumptive taxation scheme can increase the discretionary power of tax officials and in a worst case scenario increase corrupt practices. A carefully designed presumptive taxation scheme can help reduce corruption, but can never be a substitute for the much needed capacity building and administrative reforms within the tax administration.
Undermines Tax Base
The primary goal of most governments that introduce presumptive taxation is to broaden the country’s tax base by preparing citizens and businesses in the informal sector to enter the formal tax net. However, presumptive taxation has proven to undermine this goal as taxpayers remain in presumptive taxation regimes indefinitely or regress from formal taxation programs to presumptive taxation schemes. This phenomenon tends to occur when sophisticated taxpayers earn above average income and recognize that standard assessments levy a lower tax burden. The result is that they either under report income or simply pretend not to keep accurate records of income, as is prevalent in Israel, in order to remain in the presumptive regime and enjoy its benefits.
Overall, presumptive taxation is a form of assessing tax liabilities using indirect methods such as income reconstruction or by applying base-line taxation across the entire tax base. Presumptive methods of taxation are thought to be effective in reducing tax avoidance as well as equalizing the distribution of the tax burden. It is safe to say then, that the essence of Presumptive Tax as adopted by the FIRS is to suppress the burden of VAT on the informal sector especially micro and small businesses.