Fiscal policy and taxation

MSMEs can form the bulk of taxpayers in most countries. However, micro and small enterprises are the major contributors to the informal economy operating outside of a country’s tax net. In many developing and transition countries, MSMEs are the most rapidly growing business segment.

Taxation is often an intricate policy area, and compliance with tax law can impose significant challenges on MSMEs that do not have access to specialized accounting and legal services. How businesses are taxed also affects the decisions of MSMEs to either formalize or remain informal, with the attendant benefits (or duties) that formalization brings. Their characteristics and tax compliance vary. On the one hand, many MSMEs register with the tax authority voluntarily or due to enforcement actions. On the other hand, high costs, complex formalization procedures, or the expectation of gaining a comparative advantage from not complying with tax obligations drive many small businesses into operating in the informal economy.65

Incentives and disincentives created by taxation can alter the shape a business takes. Where taxes are numerous and the frequency of tax contributions is high, compliance with tax law can become unnecessarily onerous for MSMEs due to a lack of knowledge on taxation. Even where taxation is imperfectly designed, however, businesses can often continue to perform as long as the enforcement of the tax code is predictable and stable.66 Nevertheless, corruption and changes in regulation can contribute to uncertainty in the taxation environment, with its attendant disincentives to business activity. Furthermore, a business environment with high taxes or taxes that are challenging to comply with influences businesses’ formalisation decisions. Taxes that are difficult to understand, and rely on complicated filing procedures, make compliance of companies with their tax obligations less likely.67 Simplifying taxation procedures can reduce the costs of business formalization, and therefore create benefits for revenue collection, collection of accurate statistics, policy implementation, and worker protection and wellbeing.

Governments take many measures to reduce these impacts, providing tax preferences and simplification measures targeted at MSMEs. Tax preferences are also intended to assist with other challenges MSMEs face and support their creation and growth. Careful targeting of special tax rules for MSMEs can help ensure they meet their policy objectives cost-effectively, such as simplifying formalities and reducing costs for creating new companies.68 The taxation of MSMEs and the provision of MSME-specific tax rules can, if appropriately designed, play a beneficial role in addressing the challenges and the disproportionately high tax compliance burdens faced by MSMEs. Here, improvement of the relationship between MSMEs and public agencies, particularly tax-related bodies, via online platforms has shown to be very effective.69

Understanding the role of the tax system in the decisions of MSMEs is critical in providing policy solutions to support their success. Research shares insights into the influence of tax systems on MSMEs globally. Tax systems often offer incentives for MSMEs to incorporate and distribute income in the form of capital, particularly in the form of capital gains, which is often lower-taxed. In addition, some tax systems can disproportionately affect MSMEs to the extent that profits and losses are treated asymmetrically, with a bias towards debt over corporate equity, and impose relatively higher compliance costs.70

From a tax perspective, MSMEs taxable income often rises steadily with firm size, as does the proportion of businesses subject to double-level taxation. The OECD finds that many tax systems provide incentives to incorporate and distribute income in the form of capital, particularly as capital gains. In addition, certain features of the tax system may inadvertently disadvantage MSMEs relative to larger enterprises. These features included the asymmetric treatment of profits and losses, a bias towards debt over equity and higher fixed costs associated with tax and regulatory compliance regimes71.

Measuring the burden of tax compliance on firms is difficult. While total business tax compliance costs tend to be higher for large companies, compliance costs as a proportion of revenues are higher for MSMEs.72 The volatile environment created by significant shocks such as the COVID-19 pandemic can result in a rapidly changing policy environment. With new measures being frequently introduced or adjusted by governments in response to the crisis, MSMEs can find fewer resources to adapt to new policies, stay informed on available assistance and have a more difficult time applying for assistance programmes compared to larger businesses.73 Furthermore, the need for companies to learn about, train staff, and implement solutions to deal with tax changes resulted in additional compliance costs to MSMEs.

Instead of applying different tax rates by business sizes, the government introduced specific business size thresholds to determine whether certain taxes needed to be paid. As well as being a subsidy for MSMEs because they pay a lower rate of tax (zero, if they are excepted from a given tax), there is the added benefit that they avoid the actual labour of calculating and paying the tax. A recent and significant example of this is the introduction of the GST in India (see Box 8 below).

Box 8. India’s exemption of MSMEs from GST payments

The introduction of a goods and services tax (GST) in 2017 had the effect of vastly simplifying India’s tax landscape as it replaced numerous existing taxes at the federal and state level.74 This reduced the differences between tax systems of India’s many states and while the changeover period has been difficult regarding compliance, the resulting system is more straightforward to navigate.

While the introduction of the GST streamlines matters from the perspective of business being conducted across Indian states, the implementation chosen nevertheless settled on multiple different bands, or rates, of GST on various goods. This means that compliance is still considerably costly when contrasted against regimes that have only a single GST rate. Observers such as the World Bank also note that India’s taxation environment contains “a host of tax, subsidy, and protective policies for specific activities and categories of firms, whose rationale remains unclear.”

75Taken together, the introduction of the GST has significantly improved the compliance landscape for Indian firms but there remains room for further reform.

Many of the protective taxes, subsidies and policies referred to above relate to MSMEs, and the GST is no different. In fact, MSMEs below a certain threshold are not obligated to pay the GST at all. The threshold is either 4 million or 2 million Indian rupees in aggregate annual turnover, depending on state, and does not apply to MSMEs that are trading between states.

The task of complying with the new GST was taken seriously by the Government of India and it proactively undertook outreach programmes, set up conferences and utilized social media to inform businesses and consumers about the new system. Prior to implementing the reform, an advance ruling mechanism was available to allow stakeholders to receive advice on proposed or extant transactions that would be affected.

Source: McCarthy, Benjamin. "The impact of macroeconomic policies on micro, small and medium-sized enterprises." ESCAP (2021).

Further, another primary issue affecting MSMEs is the disproportionately high impact that regulatory requirements and tax compliance costs have on them. Even though many tax requirements may appear relatively “neutral” for businesses of all sizes, the significant fixed costs associated with compliance represent a higher cost for MSMEs as a percentage of sales and income. Consequently, the tax requirements can cause a more significant adverse impact on MSMEs than on larger businesses.77

Many governments provide support to MSMEs through special tax rules, including tax preferences and tax simplification measures for MSMEs. These measures include special small business corporate tax rates; more tax deductions; tax credits or tax exemptions; preferences that apply directly to the owner or investor of the MSME. Consequently, these measures provide relief for initial investment, ongoing income, or disposal of the MSME’s assets; special simplification rules, including special presumptive tax regimes for small enterprises and special MSME replacement taxes (presumptive or cash flow).78 Box 9 shares an example from Singapore.

Box 9. Singapore’s “New Company Start-Up Kit”

In Singapore, the first tax filing was a key pain point for newly-incorporated SMEs; thus, policymakers focused on developing a digital onboarding tool for newly-incorporated companies to help them set up correctly from the start and build confidence in them. Therefore, the IRAS developed a digital onboarding tool that provides relevant, bite-sized tax-related information to newly-incorporated companies at the point of incorporation of their business to have ample time to prepare and fulfil their tax requirements. The digital onboarding tool, called the ‘New Company Start-Up Kit’, helps newly-incorporated SMEs generate a tailored filing timeline, displaying critical information such as tax filing due dates, based on the business’ date of incorporation and first financial year-end. Through the Start-Up Kit, SMEs will receive filing reminders at an email address of their choice, as well as advice on any subsequent steps they need to take.

Source: https://www.tech.gov.sg/media/technews/simplifying-tax-experience-for-small-and-medium-enterprises

Separately, the design of government tax programmes for MSMEs, including special tax rules, can address market failures and the disproportionately high compliance burdens they face. Tax programmes designed with specific objectives can effectively promote the creation, innovation and growth of MSMEs. Turkey has introduced tax deduction programmes to encourage angel investment MSMEs (see Box 10 below).

Box 10. Licensed business angel investors in Turkey

With the aim of increasing the availability of equity financing for MSMEs, Turkey introduced a tax deduction for licensed business investors as part of a wider law regarding the regulation and promotion of business angel investments. It hopes to institutionalize business angel investments and to improve business culture and ethics in the angel investment market. Further, licensing will improve the data collection regarding business angel operations in Turkey.

Licensed business angel investors can deduct 75 per cent of the capital that they invest in innovative and high growth MSMEs from their annual personal income tax base. The annual deduction is capped at TRy 1,000,000. However, licensed business angel investors can co-invest in the venture capital firms. The amount of investment that is eligible for tax support in those co-investments is TRy 2,000,000. In order to be accredited as a business angel by the Treasury, certain qualifications are required, pertaining to the wealth and income of the investor as well as his or her experience as fund manager of a financial institution, manager of a business or member of a business angel network. The 75 per cent deduction rate will be increased to 100 per cent for those investors investing in MSMEs whose projects are supported by Ministry of Science, Industry and Technology, the Scientific and Technological Research Council of Turkey (TÜBİTAK) and Small and Medium Enterprises Development Organization (KOSGEB) in the last five years. The given licenses will be valid for 5 years and the tax deduction will be applied until 2017 with the option to extend it for another five years.

Certain conditions have to apply in order to be eligible for this tax deduction. The MSMEs’ shares that are not traded at stock market must be held by the investors for at least two years. Moreover, it only applies investments in businesses with annual net sales of TRy 5 million or less and 50 employees or fewer. Between 15 February 2013 and 1 July 2015, 313 business angels have been licensed out of 321 applicants. In the same period 6 investments benefitting from the tax incentive have been made for a total amount of TRy 2,650,882.

Source: TBAA Home Page - Business Angels Association of Turkey

The drop of government revenues due to the reduction of the tax burden would be partially compensated by a broader tax base (i.e., by a decrease of tax exemptions) and in the voluntary compliance of taxpayers.  Reduction in the tax burden may result in reduced tax evasion and increase the voluntary compliance of taxpayers. Consequently, governments can clearly define taxable bases, improve enterprises' cost accounting practices, and extend the list of tax-deductible items for enterprises to further reduce the tax burden.79 

On tax administration, improving the legal protection of businesses can restrict excessive intervention by controlling authorities in the business operations of MSMEs. Also, there is room to introduce legislation on improvements to the system for submitting reports and calculating tax for MSMEs, i.e. changing reporting from a monthly basis to a quarterly basis. Further, an argument can be made in favour of payment of a single tax instead of all federal and local taxes and charges (except trade, licensing and registration duties). The rate of a single tax can vary according to the industry in which the MSME operates. The shift to a simplified taxation system can see a significant reduction in the tax burden of MSMEs and provide less cumbersome tax administration procedures while reducing costs, particularly in bookkeeping and reporting.


Policy recommendations
While many MSME tax rules are designed to support the growth and profitability of MSMEs, their design and introduction can lead to undesired impacts by giving businesses an incentive to remain small or to split up into different companies to continue benefiting from the preferential tax treatment. Thus, preferences need to be targeted and designed to overcome specific economic or tax difficulties. Policymakers can consider the following measures in developing and implementing sound policies to encourage the creation, growth and innovation of MSMEs:

  • Implementing special tax rules for MSMEs can reduce the tax compliance costs and potential distortions on regulatory impact. Tax holidays can promote the creation and development of startups.
  • Exploring specific preferences and simplification measures toward newer MSMEs, which are often affected by finance and cash flow difficulties, face barriers to entry and growth from other businesses, and compliance cost burdens. Reducing corporate tax rate to incentivize investment and expand funding in MSMEs
  • Expanding relief from tax audits for a more comprehensive number of MSMEs to promote business on growth.
  • Simplifying digitalized tax return filing, online verification of taxpayers, electronic invoicing to facilitate compliance. By doing so, GST compliance becomes easier for MSMEs. Process simplifications through technology adoption offer many advantages in lowering compliance costs by streamlining and reducing the steps required to comply. They can, therefore, be a powerful tool to enhance compliance and reduce costs.80
  • Educating MSMEs and informal sectors about tax systems and administration to encourage business formalization and minimize tax evasion practices.

The macroeconomic environment naturally affects the performance of enterprises. The buffers that enable MSMEs to withstand difficult periods may be lower than those in more extensive and more developed businesses. For MSMEs,  cash reserves and inventories are lower, and the supplier network is smaller; thus, adjusting to a bad macroeconomic environment can be more complex than for large enterprises.81 As they are more reliant on traditional bank lending, during crises, MSMEs can find their sources of finance dwindling more rapidly than larger enterprises, which have access to a wider variety of financing, including securities markets which are normally not open to MSMEs.

Subsidies are a powerful instrument of the government expenditure policy. On the domestic level, subsidies affect domestic resource allocation, income distribution, and expenditure productivity and may affect structural and sectoral adjustment by reducing the economy's flexibility. Current subsidies found in the Asia-Pacific region include funds to support entrepreneurship that incorporate training programmes and assistance for entrepreneurs; advancing online shopping platforms and promoting locally produced products; micro credit financing for women entrepreneurs; funds for encouraging investments in technology, funding for innovative agricultural production and niche products; and building resilience in the supply chains.

Wage subsidies and tax exemptions can support MSMEs in specific sectors such as tourism that the current pandemic has severely impacted throughout the region. Also, employers who hire fresh graduates for vocational/apprenticeship programmes can receive funding for undertaking such programmes. Wage subsidies and tax exemptions can be directed toward helping marginalized groups such as people with disabilities, women, former convicts, senior citizens, the long-term unemployed, and workers who have been laid-off (unemployment social security payments). Tax exemptions can be used to green MSMEs, making it more profitable for them to undertake business practices that reduce plastics, water consumption and adopt other green concepts.

During the COVID-19 pandemic, governments globally have been pushed to initiate policies to support macroeconomic activity, pushing back against the enormous economic downturn resulting from this pandemic. A broad range of policies has been used across the region, with differing effects on MSMEs. These policies entail providing subsidies, grants or reducing fees for necessary government licenses or registrations. Some macroeconomic support policies, particularly those widely utilized during the COVID-19 pandemic, are categorized in the below discussion as financial relief, wage subsidies, and strategic support.82

Governments have provided financial relief in many different forms. Liquidity support has been one of the most prominent support measures for businesses during the COVID-19 pandemic. Examples are seen throughout the region include:

Table 2. Financial relief implemented by certain governments in Asia-Pacific

Country Financial Relief
Thailand The Bank of Thailand has provided loans to businesses, created a bond stabilization fund to support the secondary securities market, and implemented tax relief policies83, some explicitly targeting MSMEs.
Thailand also introduced measures to allow MSMEs to claim tax deductions on interest and salary payments.84
China The State Council announced changes to VAT that would reduce the economic impact of the pandemic on MSMEs.  In Hubei province, the epicentre of the COVID-19 disease, MSMEs were made exempt from VAT, while in other provinces, the VAT collection rate was brought back to 1 per cent rather than the usual 3 per cent.85
Armenia The government introduced subsidized short-term loans during the COVID-19 crisis and direct employment subsidies to assist MSMEs in maintaining their employment number.86
Republic of Korea The government exempted small businesses (defined as being below a particular level of turnover) from VAT payments.87
Vanuata Financial relief to small businesses (those with turnover less than 200 million Vanuatuan vatu ($1,800,000) by refunding the cost of their business license fees.88

Government subsidies are also applicable in developed countries, particularly during a crisis. The United States has implemented its  Paycheck Protection Programme, which grants low-interest loans to small businesses for payroll and utility and rent costs. This programme effectively promoted the survival of microenterprises89 that find the subsidy timely and helpful to cover labour costs critical for business survival as the crisis continues.

Governments can use wage subsidies in ‘normal’ economic times to encourage the employment of specific categories of people (for example, low-income workers, people returning to work after unemployment, or people with disabilities). As a crisis measure, though, wage subsidies can be extended to encompass more people and businesses as a way to maintain employment levels during an economic shock, employees to retain their skills, and smooth disruptions in the labour market.90 Examples of wage subsidies offered in the region include:

Table 3. Wage subsidies offered by certain governments in Asia-Pacific

Country Wage Subsidies
Australia The JobKeeper programme has paid out a wage subsidy to businesses that have experienced a significant fall in revenue on the condition that they continue to employ their employees over the period in which they claim the subsidy. While this subsidy is offered to both small and large businesses, the eligibility threshold is more generous for small businesses than for large businesses: businesses with an aggregated turnover of more than 1 billion AUD (around $ 775,415,000.00) must experience a revenue fall of 50 per cent to be eligible for the subsidy, while smaller businesses need only experience a drop of 30 per cent.91
Vanuatu In response to the COVID-19 crisis, the Employment Stabilization Payment reimburses employers 30,000 vatu ($274) for each employee for up to four months.92
Japan The employment Adjustment Subsidy, in which government subsidizes the paid leave allowances of workers for businesses forced to reduce staffing due to revenue declines. While large enterprises receive a subsidy for half of the leave allowance, SMEs are favoured by receiving a subsidy for two-thirds of the leave allowance.93

Governments can offer strategic support to select industries during any crisis. This may not necessarily be directed explicitly towards MSMEs, but depending on the kind of support made available by governments, it can affect them. In response to the COVID-19 pandemic, for example, governments strategically intervened in health, trade, travel and pharmaceutical industries in an effort for these industries to better withstand the disruptions being caused by the new virus. Following are some strategic supports implemented by governments during the COVID-19 pandemic:

Table 4. Strategic support implemented by certain governments in Asia-Pacific

Country Strategic Support
Republic of Korea Set up a 40 trillion won “Key Industry Stabilization Fund” to bolster industries such as aviation, shipbuilding, shipping, and automotive manufacturing, which are not sectors with a significant MSME presence.
India Allocated 150 billion rupees to be spent on health infrastructure
Bhutan The ‘Build Bhutan Project’ specifically targeted the construction industry by subsidizing the wages of workers.
Resources

65ILO, Decent work country programme for Lao PDR 2017-2021;

66 W. Buiter, R. Lago and H. Rey, Enterprises in Transition: Macroeconomic influences on enterprise decision-making and performance, Centre for Economic Performance Discussion Paper no. 340, London School of Economics and Political Science, March 1997: 14-15.

67 World Bank Group and PwC, Paying Taxes 2018, p. 42.

68 ILO June 2020 - Enterprises Department, SME Unit Enabling Environment for Sustainable Enterprises and the Post- COVID-19 Rapid Response

69 Economic Research Institute for ASEAN and East Asia (ERIA), Study on MSMEs Participation in the Digital Economy in ASEAN (2019), Nurturing ASEAN MSMEs to Embrace Digital Adoption 

70 ADB. 2016. A Comparative Analysis of Tax Administration in Asia and the Pacific 2016 Edition, p. 4. Manila: ADB.

71 Taxation-SMEs-OECD-G20.pdf

72 OECD Centre for Tax Policy and Administration, SME Tax Compliance and Simplification, Background note prepared for a ‘Roundtable discussion’ at the 1st meeting of the Working Group on Taxation of the SEE Investment Committee, October 2008: 2, see also Phil Lignier, Chris Evans, and Binh Tran-Nam, “Tangled Up In Tape: The Continuing Compliance Plight of the Small and Medium Enterprise Business Sector” 2014 Australasian Tax Teachers Association Conference, January 2014.

73 WTO, “Information note: Helping MSMEs navigate the COVID-19 crisis”, June 2020, Geneva: 4.

74 IMF, “India: Selected issues”, IMF Country Report No. 18/255, August 2018, Washington: 4.

75 World Bank, India: Systematic Country Diagnostic, 2018, 46; see also OECD, “Taxation and Investment in India”, OECD Economics Department Working Papers No. 1397, June 2017, 15-21.

76 World Bank Group and PwC, Paying Taxes 2018, pp. 52-53.

77 Ibid.

78 World Bank, Small Business Taxation in Transition Countries Michael Engelschalk, Washington, D.C.

79 Slemrod, J. and S. Yizhaki (2000). “Tax avoidance, evasion and administration”, Research Working Paper No.7473 (National Bureau of Economic Research).

80 Taxation-SMEs-OECD-G20.pdf.

81 WTO, “Information note: Helping MSMEs navigate the COVID-19 crisis”, June 2020, Geneva: 4.

82 McCarthy, Benjamin. "The impact of macroeconomic policies on micro, small and medium-sized enterprises." ESCAP (2021).

83 World Bank, Thailand Economic Monitor July 2020, International Bank for Reconstruction and Development/World Bank, Washington DC: 37.

84 International Chamber of Commerce, ICC Statement: Tax Measures to Save Our SMEs in Response to COVID-19, April 2020.

85 Lu, Lewis, “China announces tax relief measures to tackle coronavirus disruption”, published on International Tax Review (online), February 2020 (accessed on 14 October 2020 at https://www.internationaltaxreview.com/article/b1kjjn20mxcfyj/china-announces-tax-relief-measures-to-tackle-coronavirus-disruption).

86 IMF, “Policy Responses to COVID-19” (online), https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19, accessed 11 January 2021.

87 International Chamber of Commerce, ICC Statement: Tax Measures to Save Our SMEs in Response to COVID-19, April 2020.

88 IMF, “Policy Responses to COVID-19” (online), https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19, accessed 02 September 2020.

89 Robert P. Bartlett III, and Adair Morse, Small business survival capabilities and policy effectiveness: Evidence from Oakland, Working Paper no. 27629, National Bureau of Economic Research, 2020.

90 ILO, Factsheet: Temporary Wage Subsidies, May 2020, International Labour Organization, Geneva: 1.

91 Australian Taxation Office, “Eligible employers” (online), https://www.ato.gov.au/general/jobkeeper-payment/employers/eligible-employers/, accessed 02 September 2020.

92 IMF, “Policy Responses to COVID-19” (online), https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19, accessed 02 September 2020.

93 ILO, Social protection responses to the COVID-19 crisis, Regional Office for Asia and the Pacific, International Labour Organization, March 2020; and JETRO, “Employment Adjustment Subsidy” (presentation), May 2020.

94 Kuensel Online, “Build Bhutan Project comes with incentives for jobseekers in construction sector” (website), available at https://kuenselonline.com/build-bhutan-project-comes-with-incentives-for-job-seekers-in-construction-sector/, accessed 14 October 2020.