The Evolution of the Informal Economy and its Implications for Tax Policy in Zambia

Abstract

Despite the introduction of taxation into Zambia‟s largest employer- the informal economy- the contributions of these taxes to domestic revenues have been insignificant since their inception in 2004. This poor performance has led civil society organisations and even Government to call for more taxation of informality than currently exists. No estimates on the tax potential of the informal economy are available and so, it is difficult to tell whether this underperformance is largely due to ineffective taxation or rather, that that scope for taxation of informality is not considerable. With paucity of literature on the informal economy‟s tax potential, there exists no evidential basis for future tax policy regarding informality. This study uses the currency demand approach in a Vector Error Correction (VEC) framework to provide insights into the evolution of informality and its tax potential during the period 1973-2010. It was found that during the relevant sample period, informality averaged 47.7 percent of official GDP and grew at a rate of 2.7 percent per annum. Further, the maximum potential tax revenue forgone by not taxing informal economic activities was estimated to be about 7.7 percent of GDP per annum or equivalently 42 percent of the total tax revenues per annum. In practice however, only a fraction of this potential can be actually realised. In the short run, the scope for further taxation of informality is non-existent because this tax potential is spread thinly across the 4 million-plus individuals who work in the informal economy. Thus, the long run approach should be to simplify the tax system and minimise the differential treatment between taxpayer types so as to encourage the ease of graduation of the micro and small and medium scale enterprises into the standard tax structure. This entails introducing both „consumer taxes‟ and „profit taxes‟ to the informal economy albeit to a segment only– The urban informal sector which is lucrative–to minimise distortions in the economy