4.2 Distribution of ISPC Taxpayers in Mozambique: 2010 versus 2015

62 b oostin G Pro D u C tivity in s ub- sA h A r A n Afri CA

advantage of scale economies, inducing small-business traps.

The resulting negative impact on production is sizable: estimates from calibrated models suggest that interventions reducing the average size of production units by 20 percent lead to an output contraction of 8 percent (Guner, Ventura, and Xu 2008). Furthermore, although market failures sometimes warrant size-dependent interventions in the short or medium run, the dynamic inefficiency resulting from inertia amplifies the long-run reduction in aggregate production because of the negative impact of such well-intended policies on firm growth (Buera, Moll, and Shin 2013).

Preferential tax regimes for small taxpayers can create disincentives to firm growth. Evidence shows that, to minimize their tax liabilities, firms tend to bunch below the regulatory thresholds created by these regimes (Asatryan and Peichl 2017; Brockmeyer and Hernandez 2016). For example, small taxpayers in Mozambique were offered a simplified tax on gross turnover, called the Simplified Tax for Small Taxpayers (ISPC). Since 2009, this tax replaced the corporate income tax, the personal income tax, and the value added tax. A flat tax rate of 3 percent was imposed on taxpayers with annual business volumes below Mt 2.5 million, while those with business volumes below 36 times the minimum wage were exempt from the tax. A significant bunching of small firms emerged below the eligibility threshold in Mozambique after the ISPC was introduced, as shown in figure 4.2 (Swistak, Liu, and Varsano 2017).

Removing size-dependent tax enforcement in low- and middle-income countries would increase TFP, with productivity gains amounting to 0.8 percent (Bachas, Fattal-Jaef, and Jensen 2018). Making tax systems size-neutral would significantly attenuate inefficiencies in the allocation of resources. Size-dependent policies that generate small-business traps must be eliminated because they implicitly subsidize the least-productive firms and tax the most-productive ones. If governments are to provide tax incentives to spur growth, they should target productivity-enhancing investments to minimize the adverse allocative impact of distorting marginal products. If aimed at relieving the proportionally high fixed costs faced by start-ups, policies should aim at facilitating entry rather than subsidizing small firms.

In Ghana, switching from a size-dependent tax to a uniform rate would substantially raise per capita income. Gollin (2006) calibrates the span-of-control model of Lucas (1978) with self-employment technology and dynamics that match the manufacturing sector’s firm-size distribution in Ghana. Ghana’s tax policy environment, which includes a three-tiered tax scheme, is compared with a revenue-neutral counterfactual in which the rate of taxation is uniform across firm size. The simulation generates substantial labor reallocation from own-account to wage employment and estimated efficiency gains that amount to an increase of 6.5 percent in per capita income. However, it does not greatly reduce the prevalence of small firms.

FIGURE 4 .2 Distribution of ISPC Taxpayers in Mozambique: 2010 versus 2015

120

Number of ISPC taxpayers 90

60

30

0

10 15 20 25 30 35 40

Turnover (Mt 100,000)

2010 2015

Source: IMF 2017, using data from Swistak, Liu, and Varsano 2017. Note: The horizontal axis designates the turnover bins (as multiples of Mt 100,000) by which the business taxpayers are classified. The vertical rule designates the business eligibility threshold for the Simplified Tax for Small Taxpayers (ISPC), to the right of which taxpayers are ineligible. A small number of ISPC taxpayers appear above the threshold, possibly because the registration requirement is applied to turnover in the previous year instead.

Po L i C ies A n D i nstitutions th A t Distor t r esour C e A LL o CA tion in s ub- sA h A r A n Afri CA 63

Tax-induced distortions can have significant dynamic implications on resource misallocation through the impact that the corresponding allocative inefficiencies have on the firms’ incentives to invest in productivity-enhancing technologies. As a result, these firms will exhibit slower lifecycle productivity growth and hence slower employment growth. Empirical evidence shows that productivity growth over a firm’s life cycle is flatter among Sub-Saharan African countries relative to more-efficient benchmarks. For example, revenue productivity (TFPR) increases steadily with the age of the establishments in Ethiopia but at a slow pace. This suggests that older firms face bigger distortions. In contrast to the Ethiopian example, older firms in Ghana and Kenya tend to exhibit smaller TFPR as firms age. In sum, tax-induced distortions tend to decelerate firm growth over the cycle and discourage the adoption of productivity-enhancing technologies (Cirera, Fattal-Jaef, and Maemir 2018).

Overall, leveling the playing field regardless of firm size would also generate large productivity gains. Independently of government revenue considerations, better-functioning tax administration would generate productivity gains by putting an end to the distortive implicit subsidies enjoyed by informal, typically low-productivity firms. Moreover, reducing compliance costs would play a part in spurring growth by reallocating resources toward productive activities.

Informality-Related Issues

Informality is widespread in low- and middle-income economies, especially in Sub-Saharan Africa. Informal firms account for up to half of aggregate output in lowincome countries, and they typically circumvent taxation. Tax avoidance or evasion and other nonremitted contributions constitute the main benefit from informality (Fajnzylber 2007). Tax compliance increases with development, as the gradual construction of functioning legal and regulatory frameworks makes it more attractive for firms to operate in the formal economy.

Informal, noncompliant firms are significantly less productive than formal, tax-compliant ones. At the country level, there is a significant negative correlation between country TFP and the extent of informality. Firm-level evidence suggests that noncompliant manufacturing firms in low- and middle-income economies have lower productivity than their compliant counterparts; for example, businesses that only report 30 percent of their sales have, on average, a 4 percent lower TFP than those reporting a greater proportion of their sales (IMF 2017).

Informality is a source of misallocation and hinders productivity. The relative cost advantage enjoyed by noncompliant firms affects business dynamism by distorting creative destruction and growth. In this context, informality enables the survival of unprofitable businesses—thus increasing their participation in aggregate output at the expense of more profitable and compliant firms. Differences in the size distribution of all firms relative to formal firms signal the misallocation that arises from such inefficient growth dynamics. The pervasiveness of this resource misallocation is illustrated in the size distribution of manufacturing firms in Cameroon, Rwanda, and Zambia (figure 4.3) (Cirera, Fattal-Jaef, and Maemir 2018).

The size and scope of the informal sector plays an important role in explaining productivity differences within sectors and across countries. General equilibrium model simulations suggest that countries with high entry and operation costs in the formal sector as well as weak debt enforcement tend to have greater allocative inefficiencies and a larger share of output produced by low-productivity informal firms. These frictions tend to generate large informal sectors and exacerbate the misallocation of capital, thus explaining a decline in TFP of up to 25 percent (D’Erasmo and Moscoso Boedo 2012). In other words, the model yields a strong negative association between income per capita and the size of the informal sector.

Finally, incomplete tax enforcement can reduce the capital intensity of informal