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Factors Affecting Tax Compliance of Small and Medium Scale Enterprises

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  • Category: Tax

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Tax compliance has been a topic of great interest to Revenue authorities especially in the developed countries. Hostility towards tax compliance is an age old problem. “Taxes are considered a problem by everyone. Not surprising, taxation problems date back to the earliest recorded history” (Taxworld Organization, 1999).

Developing countries, perhaps due to their frequent budget deficits have not been able to conduct comprehensive research on the behavior of taxpayer in relation to compliance. Hostility between the taxpayers and tax collectors on issue relating to tax compliance is evidenced by frequent tax evasion reports in our local newspapers (Juma, 2010) and outward resistance from taxpayers for example the recent protest by taxpayers over implementation of Electronic Tax Registers.

Hostility towards tax compliance could be explained in terms of the deterrence theory which implies that taxpayers make calculations of the economic consequences of different compliant alternative, such as whether or not to evade tax; the probability of detection and consequences thereof, and choose the alternative which maximizes their expected after tax-return/profit possibly after adjustment for the desired level of risk (Trivedi, Shehata & Mestelman, 2005). Hostile taxpayer’s behavior implies that given a chance taxpayers would not comply with tax laws.

Hostility towards tax compliance could also be explained by the expected utility theory which is an economic analysis that frames the decision to pay as a rational attempt to maximize ‘profits’ (Grant & Van Zandt, 2007). The basic assumption is that people are free riders: no one will voluntarily contribute tax unless the threat of punishment makes it sensible. Thus, traditionally, tax evasion has been understood in terms of the benefits of successful evasion weighed against the risk of detection and punishment Hessing and Elffers (1993) treat tax evasion as defective behavior within asocial dilemma.

It is the social dilemma which has made tax of interest to social psychologists. Just as the tax system confronts people with the choice between co-operative behavior (paying taxes in full) and non-co-operative behavior (evading some or all taxes), so does the social security system: individuals would be better off if they broke the rules, but the whole system would break down if it was abused by all.

More recent tax evasion research supports the claim that as well as the risk of discovery and punishment, non-economic factors also nfluence taxpaying behavior, for example, ethics, perceived fairness, social norms, psychological orientation and‘tax morale’ (Alm and Torgler, 2006; Cowell, 1992; Kirchler, 1999; Wenzel, 2002, 2004). A number of such social psychological factors have been used to explain the complexity of taxation compliance behavior. Kenya is ranked among low-income countries or low-compliance countries with hard task of ensuring efficient and effective tax administration.

Kenya Revenue Authority is supposed to promote compliance with Kenya’s tax and to ensure responsible enforcement by highly motivated and professional staff thereby maximizing revenue collection at the least possible cost for the social-economic well being of Kenyans” (CIAT, 2006). KRA administers different types of taxes under different Laws (Acts) such as Income Tax, Value Added Tax, Custom duties and Excise Tax among many others. Hence, KRA is supposed to ensure taxpayers comply with the respective tax laws. In Kenya, one of the main challenges of the Tax Modernization Program is the large informal sector.

The MSE sector in Kenya is large and growing in numbers. The first National Baseline Survey of 1993 identified 910,000 micro and small enterprises (excluding agro-based activity) employing about 2. 0 million people. The second National Baseline Survey of 1999 identified 1. 3 million enterprises with about 2. 4 million people involved. This sector requires treatment other than that provided by refined methods of tax administration and provisions in the revenue code. Small producers are notoriously difficult to tax and subsistence agriculture does not generate large surpluses.

An experiment with presumption tax (abolished in 1993 and re-introduced in 1995) was a particularly notable attempt to formalize parts of the informal agricultural sector (Cheeseman and Griffins, 2005). Further attempts focused on the use of advance tax and tax on rental incomes. However, given the invisibility of the informal sector and scarce empirical work to understand tax-relevant information, the presumption tax approach and the advance tax approaches failed to achieve the intended objectives. It is not difficult to understand why they could not work.

If the Government does not know about the income received by farmers, farm workers and small-scale entrepreneurs, it can have no prospects of taxing it. This creates the need for a proper income survey to determine the optimal tax yield, the ability and willingness to pay. The advent of the East African Community customs union further complicates the tax compliance risk management problem. In 2005, Uganda, Kenya and Tanzania signed a treaty forming the East Africa Community (EAC) customs union which has now been expanded to include Rwanda and Burundi.

The purpose of the customs union is to promote trade and other elements of regional development. The dominant feature of the customs union is that member states agreed to reduce tariffs. The Heads of State reached an agreement to implement a common external tariff with three bands, 0 percent for meritorious goods, 10 percent for intermediate goods and 25 percent for consumer goods (Obwona:2005). The members of EAC have imposed a common external tariff of 25 percent on goods from non-members of EAC (Obwona, 2005).

However, the EAC customs union presents uncertain economic impacts on member countries and has generated a great deal of public discussion and debate (Obwona, 2005). One of the uncertainties arises from the lack of understanding of what affects tax compliance of SMEs. A small and midsize business is any for-profit commercial entity other than those that exceed a given (high) asset threshold. Small businesses include sole proprietor, partnership and corporate forms of organization.

They also include individual return filers who have income from self-employment, even if self-employment income is not their primary source of income (OECD, 2010a). SMEs represent a high risk group in most countries because they are numerous and because their income is neither fixed nor, in most cases, capable of easy verification against third party data. In addition, their commercial set-ups can lack the well developed structures for record keeping, independent audit of accounts and cash handling that help to minimize risks of under-reporting in larger businesses.

The need to tax the MSE sector is therefore obvious. It arises from the need to encourage compliance; de-institutionalize tax evasion as normal part of doing business; enhance credibility of the tax system and theoretically embed tax equity; encourage the sector to carry its fiscal responsibility, create dis-incentives for the formal sector to sub-divide into smaller business entities below tax thresholds and thus erode the realized tax base and endanger internal balance which goes to exacerbate economic distortions inherent in taxation.

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