Informality and the tax gap: A case of non-farm enterprise in Ghana

  • Effective tax revenue mobilisation is important for sustained economic growth. In Ghana, tax avoidance and evasion is widespread, mainly in the informal sector, in which 86% of the country’s workforce is employed.
  • In this project, researchers estimated the revenue currently lost through tax avoidance in the informal sector. Of the potential tax revenue to be collected from the informal sector, only a third is estimated to be collected annually.
  • Researchers also broke down tax avoidance in the informal sector by gender, education, and location to find out where policies to improve tax revenue in the informal sector should be focused.
  • The findings of this project are now being used by the Ghana Revenue Authority and Ministry of Finance and has led to further studies on tax and the informal sector.

With high incidence of tax evasions and avoidance within the informal sector of many developing countries, widening the tax net to generate more revenue, without resorting to increasing tax rates, may enhance economic growth. This is because many developing countries like Ghana suffer from huge financing gaps/constraints that inhibit public sector investment in roads, energy, education, and infrastructure among others. Ghana, for instance, continues to record a high budget deficit partly on account of a low tax revenue, which is currently not more than 18% of GDP.

While low domestic revenue mobilisation being a major concern to the Ghanaian government and its development partners, there is an overarching concern that the formal sector is being overtaxed, with the informal sector being undertaxed. However, taxing the informal sector is, by the definition of ‘informal’, a major challenge.

Using the sixth round of the Ghana Living Standards Survey, this project estimates the tax gap in the informal sector by computing the difference between the potential and the actual annual tax payments. With this information, the Ghanaian government can make more effective plans towards broadening its tax base into the informal economy. Researchers found the Ghanaian government loses around 227 million cedis (over $45 million) in potential tax revenue from the informal sector each year.

The project also investigated what determines whether a non-farm informal enterprise pays tax. The study showed that several firm owner and firm level characteristics influence the propensity to pay tax in the informal sector. With regards to the firm owner’s characteristics, the study shows that male firm ownership and having at least primary education qualification significantly increases the propensity to pay tax. Also in line with expectations, the researchers’ estimates show that firm-level variables such as firm sales, bank savings, type of business, urban location, as well as experience of the firm, significantly increases the propensity to pay tax.

This knowledge has been communicated to the Ghana Revenue Authority and the Ministry of Finance for them to incorporate in to their efforts to create finely-targeted policies to broaden their tax base. The Ministry of Finance has since requested further studies from the researchers to estimate the marginal cost of tax collections from the informal sector.

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