The informal economy and hard-to-tax (HTT) sectors remain largely outside the formal tax system for several reasons. While the informal economy represents economic activity not captured in GDP figures, HTT sectors are defined by their exclusion from the effective tax base. In both cases, accurate measurement and targeted policy are crucial to bringing them into the fold.
A key challenge in taxing these sectors is their reliance on small, cash-based businesses, which often operate without leaving verifiable transaction records. This lack of documentation makes it difficult for tax authorities to trace and assess their economic activity. Additionally, high compliance costs, including complex registration and filing processes, deter many small and rural enterprises from formalizing.
Taxing small firms is also often inefficient. The cost of auditing such businesses may exceed the potential revenue gains. For example, in Pakistan, an increase in taxpayer registration between 2014 and 2021 did not result in higher revenues, as most new registrants contributed little or nothing to the tax pool. This underscores the limitations of expanding the tax base without ensuring meaningful compliance.
Governance weaknesses also discourage voluntary compliance. Many firms avoid registration due to fears of harassment and corruption by tax authorities. A lack of trust in the system poses a major obstacle to formalization efforts.
To address these challenges, a multifaceted policy approach is necessary. Smart enforcement strategies, such as the use of big data and machine learning, can help target high-risk taxpayers more effectively. Presumptive tax regimes, which base taxation on simplified metrics like turnover or land use, can reduce compliance burdens while broadening the tax net.
Technology plays a critical role in increasing transparency. Digital payment systems and e-invoicing, as seen in Brazil’s electronic receipts initiative, help reduce informal transactions and improve tax compliance. Tailored tax policies for specific sectors, such as agriculture or the professional services, can also enhance coverage through indirect methods or licensing linkages.
Incentives to encourage formalization, such as streamlined registration, tax breaks, and access to credit, have shown promise. For instance, Uruguay’s approach of linking formalization to agricultural insurance encouraged more firms to comply voluntarily.
Case studies offer further insights. Pakistan’s experience demonstrates that increasing registrations without compliance measures does not yield revenue gains. Vietnam’s gradual formalization through tax simplification and credit access led to a decline in informal employment. India’s Goods and Services Tax (GST) system incentivized registration by making input tax credits dependent on formal transactions, capturing informal revenue streams at earlier supply chain stages.
In conclusion, taxing informal and HTT sectors requires a balanced, evidence-based strategy that combines enforcement, simplification, and incentives. While the immediate revenue impact may be limited, these efforts can drive long-term economic development and equity by fostering a more inclusive and transparent tax system.
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