The Impact Of Tax Reform On Private Sector Development

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The Impact of Tax Reform onPrivate Sector DevelopmentAmin AbdellaJohn CliffordNovember 2010Produced and distributed byAddis Ababa Chamber of Commerce andSectoral Associations with financial support fromthe Swedish Agency forInternational Development Cooperation, Sida

Private Sector Development Hub/Addis Ababa Chamber of Commerce and SectoralAssociations, 2010P. O. Box 2458, Mexico Square, Addis Ababa, EthiopiaTel: 251 (0)11 550 4570, Fax: 251 (0)11 554 2404Email: psdhub@addischamber.comAll Rights ReservedNo part of this publication may be produced or transmitted in any form or by any means without theprior permission of the copyright holder. The only exception is for a reviewer, who may quote shortexcerpts in a review.Disclaimer: The views expressed in the study do not necessarily reflect the views of the PSD Hubor Addis Ababa Chamber of Commerce and Sectoral Associations or Sida. They are solely the responsibilities of the authors.

AcknowledgementThe Impact of Tax Reform on Private Sector DevelopmentThe draft report on The Impact of Tax reform on Private Sector Development wasprepared by Ato Amin Abdella based on an earlier draft written by Ato BeyeneBekele of Tademcos Consulting. Additional analysis was undertaken and the finalreport prepared by Mr. John Clifford of BKP Development Research and ConsultingGmbH.

Table of ContentsAcknowledgement .iList of Tables .ivList of Figures .ivAcronyms and Abbreviations.v1 Introduction .11.1Background . 11.2Objectives of the Study . 21.3Methodology . 21.4Scope of the Study. 32 Theoretical Basis and Literature Review .52.1Principles of Taxation and Tax Reforms . 52.2Tax Reform Models . 52.3Taxation Theory. 62.4Country experiences . 62.5Value-Added Tax (VAT) . 92.6Lessons from Tax Reforms. 133 Evolution of Ethiopian Tax Reforms and Review of the Current Tax Laws.153.1Evolution of the Tax Reforms . 153.2Current Ethiopian Tax Laws. 163.3Examination of Tax Laws, Regulations and Implementation Directives . 215 Survey of the Impact of Tax Reform on the Private Sector .315.1General Principles of Taxation . 325.2Tax Enforcement . 375.3Compliance Costs . 405.4Tax Administration . 415.5Value-Added Tax . 455.6Other Impacts of Tax Reform on Private Sector Development. 525.7Tax and Accounting Issues . 555.8Perspectives of Tax Officials and Practitioners . 576 Conclusions and Recommendations.596.1Summary of Key Findings from Business Survey . 596.2The Impact of Tax Reform on the Private Sector . 606.3Impact of the Tax System on Government Revenues . 67References .69Tax Laws . 72Tax Regulations . 72Annex A. Selected VAT Regulations and Schedules .73Annex B. Macroeconomic Data .75Annex C. Simplified Schemes for VAT Accounting .79The Impact of Tax Reform on Private Sector Development4 Recent Macroeconomic and Government Revenue Performances .254.1Recent Macroeconomic Performance . 254.2Government Revenue and Expenditure. 264.3Revenue Impacts of the Reform . 30III

List of TablesTable 1. Total Tax Compliance Burden of Selected African Countries .8Table 2. General Government Revenue and Growth Rates (2002/03-2007/08) .26Table 3. General Government Revenue .28Table 4. Primary Survey Sample Characteristics .31Table 5. Secondary Survey Sample Characteristics .31Table 6. General Government Revenue (2002/03- 2007/08) .75Table 7. General Government Revenue (1998/00-2007/09) .76The Impact of Tax Reform on Private Sector DevelopmentList of FiguresIVFigure 1. Tax revenue and Tax burdens on agriculture/non-agriculture sectors .29Figure 2. Orientation of businesses in main survey .32Figure 3. Perceived complexity of tax laws .33Figure 4. The Degree of Transparency of the Tax Law .33Figure 5. Whether businesses receive prior information on changes .34Figure 6. Taxpayer education and information .35Figure 7. The Degree of Equity of the Tax System.36Figure 8. The Degree of Neutrality of the Tax Law .36Figure 9. The Degree of Technical Capacity of the Tax Administration .37Figure 10. Enforcement mechanisms perceived as unfair .38Figure 11. Reasons for non-registration for VAT by eligible businesses .38Figure 12. Perceived Severity of Financial Penalties .39Figure 13. The Costs of Complying with Tax Laws .40Figure 14. Impacts of high tax compliance costs on business .41Figure 15. Major complaints concerning tax administration .42Figure 16. Negative and Positive Impacts of Tax reform .43Figure 17. Impacts of Subjective Tax Assessments by ERCA.43Figure 18. Length of Appeal Process by Business Sector .44Figure 19. Business Complaints about VAT .46Figure 20. Impacts of VAT on Businesses .47Figure 21. Whether businesses pass on the full amount of VAT to their customers .48Figure 22. Reasons for not being able to pass VAT onto consumers .48Figure 23. Impacts of Inability to pass on VAT in full to Consumers.49Figure 24. Opinions on VAT registration threshold .49Figure 25. Timely reimbursement of VAT claims, by business sector .50Figure 26. Impacts of Delays in VAT Refunds .51Figure 27. Tax law impact on investment .52Figure 28. The Impacts of the New Tax Law on Export Development .53Figure 29. The Impacts of the Tax Law on Domestic Industrial Development .54Figure 30. Does Your Business Keep Books of Accounts? .55Figure 31. Proposed Measures to Increase Private Sector Capacity .56

EDPITPPPPSD HubRFEDBRRASAPSIGTASSPSSTOTWTOVATAddis Ababa Chamber of Commerce and Sectoral AssociationsBusiness Income TaxCommunity of Eastern and Southern AfricaCentral Statistical AgencyEthiopian CalendarEthiopian Peoples’ Revolutionary Democratic FrontEthiopian Revenue and Customs AuthorityForeign Direct InvestmentFederal Democratic Republic of EthiopiaFocus Group DiscussionGregorian CalendarGross Domestic ProductGoods and Services TaxMinistry of Finance and Economic DevelopmentPersonal Income TaxPurchasing Power ParityPrivate Sector Development HubRegional Finance and Economic Development BureauRegional Revenue AgenciesStructural Adjustment ProgrammeStandard Integrated Government Tax Administration SystemStatistical Package for Social SciencesTurnover TaxWorld Trade OrganizationValue Added TaxThe Impact of Tax Reform on Private Sector DevelopmentAcronyms and AbbreviationsV

1 Introduction1.1 BackgroundTax reform is one of the major reforms undertaken by the government since theEthiopian Peoples’ Revolutionary Democratic Front came to power in May 1991.Tax rate and tariff reductions, overhauling the tax system and improving tax administration, and the modernization of the tax structure were among the core elementsof the tax reform.As an element of the reform, in January 2003, Value Added Tax (VAT) was introduced to replace the existing sales tax. VAT has specific characteristics which provide for taxes on services as well as goods, a zero tax rating for exports and allowsfor reduced (or zero) rates on basic products. It is contended that VAT increasesgovernment revenue, improves economic efficiency, promotes exports, and fostersgrowth.A major complaint is the perceived market distortion created by VAT, placing VATregistered businesses at a price disadvantage against non-VAT-registered businesses.Thus, it is argued, VAT-registered businesses are losing their customers to non-VATregistered businesses, thereby threatening their survival. In addition to this, the highcost to businesses of compliance with the tax laws, especially the VAT laws, is seenas a further threat to businesses.Other issues raised by the business community are that the tax burden falls disproportionately on a relatively few large, formal enterprises, while large numbers ofenterprises remain outside the tax system due to tax evasion, corruption, ineffectivetax administration, weaknesses in the structure of the tax system, and tax laws thatserve as a strong disincentive to formalization.Furthermore, there is widespread concern in the business community about the wayin which the tax laws have been implemented and the approach to assessment andenforcement of not just VAT but also profit taxes, presumptive tax and excise duties.It is, therefore, necessary to examine all these concerns regarding the impacts of thereform on business development, with the intention of making recommendationsthat inform tax policy decision-makers. This study, commissioned by the PrivateSector Development (PSD) Hub, aims to do that and thereby to provide valuableinput to the process of public-private dialogue.The Impact of Tax Reform on Private Sector DevelopmentAccording to the Ministry of Finance and Economic Development (MoFED), thecollection of tax revenue has increased dramatically since the introduction of VATin January 2003. VAT revenue as a share of total tax revenue reached 41.4 percentin 2007/08. Although the VAT system has been accepted and adopted by businessesthere have been many difficulties in its implementation and these have led to complaints from VAT-registered taxpayers.1

1.2 Objectives of the StudyThe study has an overall objective of assessing the impact of the tax reform on private sector development. This includes reviewing the new tax policy, its impact onbusiness, and making recommendations that would help improve the tax system sothat it may contribute to the growth and development of the private sector and henceto the overall economic development of the country. Specific objectives of the studyare to:Conduct an in-depth review and analysis of the reformed tax system and assess itsactual or perceived negative or positive impacts on private sector development;Investigate the tax laws, regulations and implementation directives and identify theirweaknesses and discrepancies, andRecommend measures that address the negative impacts and strengthen the positiveelements.1.3 MethodologyThe Impact of Tax Reform on Private Sector DevelopmentThe study has employed a combination of different approaches.Firstly, a survey of taxpayers, tax practitioners and tax officials based in Addis Ababa was conducted. For the survey, a sample of 29911 respondents was interviewedfrom business enterprises (both VAT-registered and unregistered, lists of which wereobtained from the Addis Ababa Revenue Agency and the Ethiopian Revenue andCustoms Authority), as well as tax practitioners and tax officials in Addis Ababa.66 percent of the respondents were VAT-registered businesses, 32 percent were nonVAT-registered businesses while the balance comprised tax officials and practitioners. Moreover, owing to the use of a stratified random sampling technique, all sectors of the economy are represented in the sample.The collected primary data were edited for consistency, coded, entered into a computer and verified, following which they were analysed. The findings of the surveyare presented in the study report in tabular and graphic forms as found appropriate.Secondly, desk analysis of secondary data such as tax and macroeconomic statisticswas undertaken to determine trends pre- and post-reform. International tax data werealso examined for purposes of comparison.Thirdly, a review of tax policy documents and literature was undertaken. In the document review an attempt was made to review tax proclamations issued over time withemphasis on the current tax proclamations, regulations and directives; and identifythe weaknesses and discrepancies therein. In the literature review, theoretical andempirical literature was examined to identify both lessons from the experiences ofother countries and good practices which could be applicable to Ethiopia.12The target sample size was 300 interviewees.

1.4 Scope of the StudyThe coverage of the survey is limited to Addis Ababa. Some 97 percent of the sampleframe of the country operates in Addis Ababa; hence conducting a rapid survey onAddis Ababa alone can provide a statistically valid result for the whole country.Moreover, the majority of VAT-registered businesses are located in the capital, AddisAbaba,The Impact of Tax Reform on Private Sector DevelopmentIt has also been possible to use some results from a previous survey, with a largersample size and greater geographical spread. It should also be noted here that theresults of the two surveys show a high degree of consistency, thus increasing confidence in the validity of the results.3

2 Theoretical Basis and Literature Review2.1 Principles of Taxation and Tax ReformsThe primary purpose of taxation is to mobilize the revenue required to finance publicgoods and services. Since taxes have a pervasive influence on economic decisionsof individuals and businesses, and on social equity, the tax system should achievethe appropriate level of revenue as efficiently and fairly as possible. Thus a welldesigned tax system should be effective in raising revenue, efficient in its effects oneconomic decisions of households and businesses, and equitable in its impact ondifferent groups in society.The commonly accepted principles of taxation are incorporated into most tax reforms, which emphasize: Ability to Pay; Equality; Adequacy; Neutrality; Broad Basing; Non-Retroactivity; Compatibility; Predictability; Earmarking; Restricted Exemption, and Efficiency; Simplicity.There is a growing body of literature about tax reform documenting the benefits,opportunities and problems, which can, in turn, represent prevention of a particulartax burden for many taxpayers. Tax reforms are based on what are usually referredto as the “Four Rs”: Raising revenue, Redistribution of wealth, Re-pricing to discourage consumption and/or to address externalities, and Representation to make clear accountability and good governance.2.2 Tax Reform ModelsRecent tax reforms have tended to focus on achieving broader based taxation at moreuniform rates and reductions in the level of tax-induced distortions that are promptedby high rates (Rao). Many tax reforms represent an effort by governments to usetax policy as an instrument to promote investment and development, and to addressgender issues as well as assisting disadvantaged groups of society.The Impact of Tax Reform on Private Sector DevelopmentThese principles provide a basis for evaluating contemporary tax reforms.5

A sound tax system has to distribute the tax burden equitably; it should create minimal distortion in economic decision-making; it should correct inefficiencies in theprivate sector and make tax administration responsive to the problems of tax payers;and it should facilitate economy in the costs of administration and compliance (Vaishand Agarwal).2.3 Taxation TheoryThis section reviews some of the empirical and theoretical literature on taxation,with an emphasis on developing countries, in order to identify important issues relevant to the tax system of Ethiopia. It is not the intention here to be

government revenue, improves economic effi ciency, promotes exports, and fosters growth. According to the Ministry of Finance and Economic Development (MoFED), the collection of tax revenue has increased dramatically since the introduction of VAT in January 2003. VAT revenue as a share of total tax revenue reached 41.4 percent in 2007/08.

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