Tax Gap Study Report_Final.pdf

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THE REPUBLIC OF ZAMBIA

Ministry of Finance

A TAX GAP STUDY

Consultancy for a Tax Gap Analysis Report

Contract No: PFMRP/101/1/6-29-2017

December 2018

Dr. Uzma Ashraf Barton Fiscal & Financial Governance Specialist

George Mason University, Arlington, Virginia, USA

Tax Gap Analysis – Draft Complete Report, Tax Policy Unit, Ministry of Finance, Zambia ii

Ms. Barton conducted preliminary mission to Lusaka in July- August 2018 and collected data, discussed issues with the various stakeholders including the Ministry of finance (the Tax Policy

Unit), Zambia Revenue Authority, the Zambia Development Agency, and a few think-tanks including the IGC, the ZIPAR etc. and completed the Inception Report.

The findings of the final report were presented, and a draft submitted to the Ministry of Finance during the final mission held in Nov-December 2018. During this mission, we conducted workshops to disseminate skills and complete knowledge transfer to the Tax Policy Unit, Ministry of Finance, Zambia. The final report benefited from the discussions with the Budget Office staff and has incorporated some of the comments made during the presentation and workshop sessions.

For this report, Mr. Andrew Mumbi Chisopo helped in data collection (locally) and data processing.

There have been some challenges in finding required data, in particular, independently available statistical data from other agencies. The Budget Office is aware of the data issues that this report is still in want of (and will be updated as it becomes available). Participants of the workshop were briefed about the specific sources of data, the relative health, credibility, and use of provisional data (where final figures are not available) for both the VAT and Excise gap analysis. We expect most of this information would be published soon and the gap analysis report can be updated for the year 2016 and 2017. Hence, the results in this report may be treated provisional. The data challenges (in terms of quality, availability and access) are generally prevalent throughout the developing countries. The author is thankful to the Budget office staff and in particular, the Project

Director for their efforts in facilitating data access especially from external agencies.

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The Government of the Republic of Zambia has in the last five years embarked on a developmental agenda to be financed largely with commercial borrowings. However, current debt thresholds indicate that continued borrowings are no longer sustainable; with copper prices remaining subdued, financing conditions have tightened substantially. This means that the Government has to realign its fiscal position through enhanced domestic resource mobilization (DRM) which can be achieved by improving tax performance and an increased tax to Gross Domestic Product

(GDP) ratio. For these strategies to work, estimating revenue potential in Zambia is an important first step.

The purpose of this study is to assess revenue potential in domestic consumption taxes (VAT and

Excise tax) in Zambia. An estimation of potential tax gaps provides a better understanding of the potential tax revenues which are not being collected under the existing revenue management system and reflects on the efficiency of both policy and administrative effort in a country. A study establishing the domestic tax space by identifying the tax gaps and calibrating the tax effort to enhance revenue potential in Zambia can potentially increase the efficiency of tax administration approaches. It is in this regard the recommendations envisaged in this study, will provide for bridging the tax gaps through legal, policy and administrative corrections across the various domestic taxes and will also fill in the research gaps that exist in the legal analysis of tax subjects in Zambia.

This study requisitioned by the Tax policy Unit (Budget Office) is part of Public Financial

Management Reform Strategy (2013-2017) - Phase I, of which Component 6 is Strengthening Tax

Policy Formulation.

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Table of Contents

ABBREVIATIONS AND ACRONYMS .................................................................................................... vi

EXECUTIVE SUMMARY ........................................................................................................................ vii

I. INTRODUCTION

1. Background of the Study

2. Statement of the Problem

3. Rationale and Objective of the Study

4. Tax Revenue Performance

5. The Methodology

A. A Note on Empirical Methods

B. A Caveat on Data

II. ZAMBIA: INFORMAL ECONOMY AND REVENUE PERFORMANCE

1. Informal (Shadow) Economy

2. Recommendation: Raising Cost of Informality

3. Regional Outlook

III. VAT TAX GAP ANALYSIS

1. Defining the VAT Gap

2. Choice of Methods for VAT Gap and Data Issues

3. Estimating VAT Gap in Zambia

4. Results

5. Recommendations

IV. EXCISE TAX GAP ANALYSIS

1. Defining the Excise Tax

2. Choice of Methods: Excise Tax Gap Measurement

3. Estimating Excise Tax Gap in Zambia

4. Recommendations for Excise Tax Gap

V. RECOMMENDATION: IMPROVING TAX GAPS IN ZAMBIA (LEGAL, POLICY, AND

ADMINISTRATION)

Recommendations: Issues of Law and Policy

Recommendations: Administrative Gaps

Tax Gaps and International Taxation - Recommendations

VI. INVENTORY ASSESSMENT FOR THE ZRA

Annexures

Annexure I: Glossary of Terms

Annexure II: Meetings Held:

Annexure III: References

List of Tables

Table 1: Summary of Key Issues and Recommendations .......................................................................... viii

Table 2: Declining Size of the Informal Economy - Zambia v

Table 3: Size of the Informal Sector and Tax to GDP: A Regional Comparison

Table 4: VAT Gap Estimates

Table 5: Excise Duty Collections as Percentage of Total Tax Revenue

Table 6: Excise Tax Rates - 2017

Table 8: Computing Excise Gap 2015 (based on LCMS consumption values)

Table 9: Excise Duty Collections by Product Type

List of Graphs

Graph 1: VAT Tax Revenue Performance from 2013 - 2017 (K' million)

Graph 2: Excise Tax Collection Trends 2014-2017

Graph 3: Product-wise Excise Tax Collection 2014-2017 vi

ABBREVIATIONS AND ACRONYMS

BOZ Bank of Zambia

CIT Corporate Income Tax

DRC: Democratic Republic of Congo

DTA Double Taxation Agreement

EBITDA Earnings Before Interest, Tax, Depreciation and Amortization

FDI Foreign Direct Investment

GDP Gross Domestic Product

GOZ: Government of Zambia

GRZ Government of the Republic of Zambia

GTZ Deutsche Gesellschaft für Technische Zusammenarbeit

HMRC Her Majesty’s Revenue and Customs

ILO International Labor Organization

IMF International Monetary Fund

ITC International Tax Compact

LCMS Living Conditions Monitoring Survey

LME London Metal Exchange

METR: Marginal Effective Tax Rate

MFEZ: Multi Facility Economic Zones

MNC Multi-National Corporations

MOF Ministry of Finance

MSMEs: Micro, Small and Medium Enterprises

PAYE Pay-As-You-Earn

SACU Southern African Customs Union

SADC: Southern African Development Community

SI Statutory Instrument

SSA Sub-Saharan Africa

TPU: Tax Policy Unit

VAT: Value Added Tax

WHT Withholding Tax

ZDA: Zambia Development Agency

ZRA: Zambia Revenue Authority vii

EXECUTIVE SUMMARY

The overall objective of the study is to establish tax space regarding domestic consumption taxes in Zambia and provide recommendations to optimize tax collection. Given a declining tax to GDP ratio (from19.5 in 1990s to 14.9 by 2016), the Government of Zambia aims to raise the necessary resources domestically through revenue mobilization while maintaining a ratio of tax to GDP at 17.7percent to finance the growing demand for social services. The tax to GDP ratio target for 2017 was 18 percent of the GDP however the actual collection remained just below the target (16.8 percent).

The government of Zambia’s expenditure to GDP ratio is about 25percent (projected at 26 percent for 2018), and current tax to GDP ratio at about 16 percent reflects a fiscal gap of almost 9 percent for 2017. The Green paper on

Zambia’s medium term expenditure framework intends to lower this deficit to 7.4 percent in 2018 and to 6.5 percent in the 2019 budget, with the aim to lower it further to 5 percent by 2021. This can be achieved by (1) maintaining an economic growth of at least 4 percent, (2) reducing debts (and thereby expenditures), and (3) tapping into the lost revenue that escape the formal sector. In this context, this report identifies and estimates potential tax gaps for domestic consumption taxes (Excise and Value Added Tax) and establishes fiscal space. The report makes recommendations to address the informal (shadow) economy in Zambia to capture lost revenue that escapes the formal sector (tax effort) and causes tax base erosion.

Tax Gap

A tax gap can be defined as the difference between total amounts of taxes due to the government versus the amount that is actually received by the government under existing statutory provisions. Measuring tax gap provides a better understanding of the potential tax revenues which are not being collected under the existing revenue management system and reflects on the efficiency of the administrative effort in a country. Identifying compliance gaps (potential revenue under the current policy less the actual revenue collected) and policy gap (potential revenue under a reformed policy less potential revenue under the current policy) can provide a better understanding of the necessary administrative and policy measures that need to be taken to enhance revenue mobilization.

Constituents of Tax Gap

The major constituents of tax gaps include underreporting of income, underpayment of taxes, businesses employing tax avoidance (legal) and tax evasion (illegal) strategies, non-filing of tax returns (when required under the law) and informal sector of economy. A tax gap is a sum of two components: compliance gap (which arises from the impact of noncompliance to the provisions of existing laws); and policy gap (arising from the impact of, or gap in tax policy). In this report, we are estimating compliance gaps in the existing VAT and Excise regime in Zambia to measure tax space and identify tax effort needed to plug these gaps.

Informal Economy

Informal economy comprises of the economic activities that contribute to the official GDP but remain unregistered with the government authorities (and thereby any income arising escapes the formal tax system). The informal economy undermines the stability of revenue collection apparatus and equity among taxpayers as large amounts of income from activities taking place in the informal sectors escape untaxed whereas in the formal sector similar activities are being taxed. According to the Labour Force Survey 2014, only 16.1 percent of total employment is in formal sector in Zambia (leaving 83.9 percent to the informal employment).

Zambia’s Development Agenda

In order to achieve its long-term development goal of becoming a middle-income nation by the year 2030, Zambia intends to raise its domestic resource base by addressing the informal sector’s tax evasion, diversification of viii economy, and controlling expenditure (by reducing debts). Zambia plans to attain an average annual GDP growth rate of 4 percent; sustain single-digit inflation within the range of 6 to 8 percent; raise international reserves to at least 4 months of import cover; increase domestic revenue to not less than 19 percent of GDP; reduce the fiscal deficit to 5.1 percent of GDP; reduce the pace of debt accumulation; and, accelerate diversification of the economy by 2021.

Revenue Performance

Zambia strengthened its revenue collection framework and has introduced institutional reforms over the last decade.

The revenues have improved considerably, from less than Kw 1.0 billion per year before 2008 to Kw 6.6 billion in

2012 (over 30 percent of total tax collection). Zambia's primary export, copper and copper-related products account for as much as 77 percent of the country's exports. Among mining countries world-wide, Zambia’s mining receipts were the second highest after Botswana in Africa, however, after 2014, despite high copper exports, the Government revenues remained lower than the global averages from mining. While natural resource taxes tend to bring in about

25-40 percent of exports in major resource-rich developing countries, these constitute only 3–5 percent in Zambia’s case.

The domestic VAT outperformed the targets in 2017. The slight underperformance in domestic revenues was driven by VAT (below target by 22 percent) and customs and excise (below target by 18 percent). Contrastingly, income tax performed slightly above expectation (by 1.9 percent) due to improved compliance. The share of VAT in tax revenue increased by 10.3 percentage points in 2017 to a contribution of 35.8 percent from 25.5 percent in 2016, mainly attributable to the withholding VAT mechanism which has significantly increased the collection of output

VAT. On the other hand, the contribution of income tax and Excise taxe declined by 9.2 percentage points and 2.3 percentage points, respectively. Domestic VAT made up 40.5 percent of the total net VAT collected in 2017, up from 1.2 percent recorded in 2016.

Methodology

To measure tax gap across a specific tax, factors such as type of tax, nature of the economic sector, class of taxpayers, and the quality and availability of data for that country can influence choice of methodology. This report adopts an empirical top-down (aggregate) approach to calculate the tax gaps in the VAT and Excise regimes.

The report provides specific recommendations to address VAT gap, Excise gap and more general recommendations to address the informal sector. Below is a summary of the key issues, findings of the study, and recommendations.

Table 1: Summary of Key Issues and Recommendations

Indicators Issues, results, challenges and Recommendations

Economic growth plan Zambia Plus economic recovery plan sets the direction for economic reforms in the medium term (by 2021) for Zambia which aims at: an average annual GDP growth rate of at least 4 percent; inflation within 6 to 8 percent; international reserves to cover at least 4 months import; increase domestic revenue over 19 percent of GDP; reduce fiscal deficit to under 5.1 percent; reduce debt; and economic diversification.

Identifying tax gaps and taking appropriate measures to plug the gaps through DRM would support achieving each of these objectives without having to raise tax rates.

The 2019 Budget is premised on DRM.

Revenue Performance Tax to GDP ratio for all the core taxes collected by the ZRA averaged around 15.76 percent.

VAT withholding mechanism brought much higher (domestic VAT) revenues; there has been resistance on the VAT withholding requirement by the market actors; income (and excise) tax collection decreased in 2017.

Zambia had lower revenue collection (tax to GDP ratio) compared to SADC.

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Informal Economy

Size

Informal sector taxation in Zambia

Recommendations

Informal sector comprises of market-based production of all goods and services (legal and illegal) that escapes detection in the official estimates of GDP.

Average size of the shadow economy in developing countries is approximately 40 percent of the official GDP; Across Africa, generally 85 percent of employment remains in informal sectors. According to the LFS 2014, 83 percent are employed in informal sector in Zambia, while over 92 percent in rural Zambia are employed in informal agriculture. Size of the informal economy in Zambia seems to be on a steady decline due to economy-wide technological advancements, automation etc.

Informal sector taxation was introduced in 2004 in Zambia with the Presumptive Tax on taxis and minibuses, and the Turnover tax (currently at 3 percent of total sales of all firms with gross turnover of up to ZMK800 million) on small-scale enterprises. In 2005 a base tax on marketers (at ZMK 500/day) was introduced. This followed imposition of

Advance Income Tax (AIT at 15 percent of the value of imports exceeding $500 in value for all unregistered and partially compliant firms) in 2007 on cross-border traders.

Strategies to seek compliance from the informal sector must take into account tax expenditure and cost of compliance. Tax potential from the informal sector may not be proportionate to the seemingly huge size of the sector. Almost 60 percent population is below poverty level. The tax thresholds under the income tax law seem to be much lower in Zambia’s case. A report in 2012 finds about 1.02 million informal and about 30,000 formal MSMEs operative in Zambia, however, only about 80,000 businesses qualified for tax (VAT) registration (at the threshold of K 2million) .

The GIZ is doing major work on the SME sector’s compliance. Taxpayer facilitation, simplifying tax procedures, rationalizing income tax thresholds, proliferating BMS can plug in major revenue leakages, and broaden the tax base. Introducing varying bands of tax thresholds within the informal sector taxation (through AIT, turnover taxes) can reduce cost of compliance (while enhance cost of informality simultaneously.

Compliance in the informal sector can best be enhanced through indirect system-wide strategies and long-term measure whereby the tax system brings SMEs and MSMEs into compliance net. Incentivizing compliance (good behavior) and dis-incentivizing informality can enhance cost-effective compliance: for example, (a) imposition of a small fee on bank transactions above a certain threshold for non-tax filers – punishing bad behavior; (b) expedited refunds for compliant tax-payers – rewarding good behavior; (c) requirement of tax-filing for persons purchasing/changing ownership of a motor vehicle, etc.

A recent measure requiring TPIN from all bank account holders can potentially set back digitalization pace of the broader population especially in rural areas (negative externalities). A graduating approach, based on pilot-implementation in major city-centers could ward off inadvertent fall-outs from lack of information, outreach, and tax illiteracy.

Inter-and intra-agency data-information-sharing arrangements over medium-term can enhance formality.

Roll out of electronic fiscal devices – if accompanied by a mass-awareness campaign possibly with the support of civil society that motivates customers to demand invoices from the businesses – could bring more formality.

Mobile Compliance Unit (MCU) to facilitate compliance and reduce cost of compliance.

Focused attention at Large-to-medium sized taxpayers.

Partnering with civil society and market-based business organization for increased awareness.

Amnesty schemes have bene known to incentivize formalization of informal sector.

Revising property valuations to reflect fair-market price; revising property tax regime remains can potentially enhance revenues -- generally in developing countries these are

0.6 percent, Sub-Saharan Africa 0.5 percent, while for Zambia property taxation brings only 0.1 percent in revenues.

Reviving the Database management System and subsequent interlinking with TPIN x would establish a strong foundation.

Enhancing legal capacity: establishing specialized tax courts and/ tribunals and instituting technical persons with judicial knowledge would empower tax courts.

Policy continuity and stability.

Empowerment of local Council’s taxation capacity; aligning public service benefits to the tax revenues.

VAT Gap

Measurement

Recommendations

To estimate the VAT gap, we calculate the effective VAT base by reducing the aggregate

VAT base by zero-rated, exempt, and supplies from businesses below the VAT threshold.

The effective tax base is then multiplied with VAT tax rate to determine potential VAT under the VAT Act to find potential total VAT liability. The difference between the potential liability and actual ZRA collections is the existing VAT gap.

Adopting tech-based VAT enforcement techniques; cross-checking information and / increasing selective audits; incentivizing formality; publishing “good and compliant taxpayers list” can incentivize filing and payment of taxes in time; publishing “white list” of taxpayers and incentivizing businesses to transact with the businesses on the white–list increases formality and compliance

Increasing rate and amount of penalties, fines; instituting automatic audit triggers for unusual refund claims; further developing transfer-pricing rules.

Excise Gap, and

Measurement

Recommendation

Excise duty is levied with a view to generate revenues from a narrow base (products with low negative externalities) involving low administrative costs. Excise tax can be used to induce negative externalities and positive benefits to other sectors by manipulating demand through increased prices.

Excise gap is the difference between potential revenue and actual revenue for a given excisable product. This report employs top-down methodology to estimate total consumption (from LCMS) and calculates potential excise base, which is compared with the actual collections by the ZRA to find the excise gap.

Rationalizing excise duty rates for substitute products (for example a large excise tax on factory made cigarettes may influence more consumption of roll your own cigarettes if the latter remains available at much lower price);

Indexing in-rem rates to count for inflation; simplifying rate structures (for the variety of petroleum products); adding more non-essential and luxury items to the excise list

Consider removing items from excise (excess taxation) like mineral water for positive externalities; employing digital/tech-based solutions to access real time production/ transaction information would increase compliance.

I. INTRODUCTION

1. Background of the Study The Government of the Republic of Zambia has in the last five years embarked on an ambitious developmental agenda to be financed largely with commercial borrowings. However, current debt thresholds indicate that continued borrowings are no longer sustainable; with copper prices remaining subdued, financing conditions have tightened substantially. This means that the Government has to realign its fiscal position through enhanced domestic resource mobilization (DRM).

The forthcoming 2019 budget fiscal consolidation is premised on DRM. Improved tax performance by increasing tax to Gross Domestic Product (GDP) ratio can help realign Zambia’s fiscal position. To increase fiscal performance, identifying economic sectors with revenue potential in Zambia is the first important step. For the past three years, revenues collected from the core domestic taxes averaged 10.9 percent of the GDP whereas tax to GDP ratios for all the core taxes collected by the ZRA averaged around 15.76 percent during the same period. Zambia’s main domestic taxes comprise of Corporate

Income Tax (CIT), Personal Income Tax (PIT), Value Added Tax and Excise duties (domestic). It is against this background that the Budget Office with the support of the World Bank under the Public

Financial Management Reform Program has commissioned this study to undertake a detailed analysis of tax revenue potential that is, establish the tax space in Zambia with respect to domestic taxes (VAT and

Excise).

2. Statement of the Problem A tax gap can be defined as the difference between total amounts of taxes due to the government versus the amount that is actually received by the government under the existing statutory provisions. An estimation of the tax gap provides a better understanding of the potential tax revenues which are not being collected under the existing revenue management system and reflects on the efficiency of both policy and administrative effort in a country. Further, identifying compliance gap (potential revenue under the current policy less the actual revenue collected) and policy gap (potential revenue under a reformed policy less potential revenue under the current policy) provide a clear understanding of the necessary administrative and policy measures that need to be taken to enhance revenue mobilization and thereby to increase tax to GDP ratio. Some tax administrations view tax gap as a major revenue source that could be used to close the government’s budget deficit without raising tax rates.

The major constituents of a tax gap can include underreporting of income, underpayment of taxes, employing tax avoidance (legal) and tax evasion (illegal) strategies, non-filing of tax returns (when required under the law) and informal sector of economy. Informal economy is a difficult to define term however in simpler terms, it is defined as economic activities that contribute to the official GDP but remain unregistered with the government authorities (and thereby remain out of tax net). For this study, in

Zambia’s context, informal economy constitutes all economic activities taking place outside the established structures of the Zambian government. More than 60 percent of the world’s employed population are in the informal economy. A new ILO report shows that 2 billion people work informally, most of them in emerging and developing countries. In Africa, 85.8 percent of employment is informal.

1 Debt service is programmed to account for 41 percent of domestic revenue in 2019 2 originally Zambia adopted VAT in 1995 however, the budget 2019 proposes to replace VAT with a simpler, non-refundable sales tax 3 Policy gap can be expressed as the difference between the tax gap and the compliance gap; and, Tax (compliance) gap is potential revenue under current policy less actual revenue collected.

The proportion is 68.2 percent in Asia and the Pacific, 68.6 percent in the Arab States, 40.0 percent in the

Americas and 25.1 percent in Europe and Central Asia.

Existence of a comparatively large informal sector in an economy can be a significant source of low tax revenues. An analysis of factors contributing to tax gap (the fiscal space) across various taxes and the effort to plug these gaps (the tax effort) can help identify strategies to raise compliance level in the tax system (and increase revenue performance). There is abundance of literature on defining and estimating informal sector particularly in the developing world. Phua quotes in his report that study on 145 countries estimates that the average size of the shadow economy in developing countries is approximately

40 percent of the official GDP.

Other national studies reveal that workers in the informal sector consists of approximately 90 percent of the total workforce (based on national survey between 1999 and 2005 period) in India, almost 75 percent in Kenya and 30 percent in the Philippines.

The informal economy undermines the stability of revenue collection and equity among taxpayers as large amounts of income from activities taking place in the informal sectors escape untaxed unlike similar activities that are taxed in the formal sector. In contrast, selected developing nations like Pakistan revealed a gap of no less than

70 percent in 2007-08.

Romania’s VAT gap in 2002 was about 45 percent while Afghanistan’s tax gap was estimated to be around 60 percent in a 2005 World Bank report.

For Zambia, there have been a few studies estimating size of the informal economy, tax evasion and mapping revenue potential in specific sectors of the economy in Zambia, however, there is a strong need to consolidate the various finding and formulate a coherent and comprehensive report. According to the Labour Force Survey 2014, only 16.1 percent of total employment is in the formals sector in Zambia (leaving 83.9 percent to the informal employment). A study establishing the domestic tax space by identifying the tax gaps and calibrating the tax effort to enhance revenue potential in Zambia can potentially increase the efficiency of tax administration. It is in this regard that this study identifies potential revenue gaps, measures the extent of compliance and proposes recommendations for bridging the tax gaps through legal, policy and administrative corrections across the various domestic taxes (VAT and Excise) and fills in the research gap that exist in the legal analysis of the tax subjects in Zambia.

3. Rationale and Objective of the Study The overall objective of the study is to establish the tax gap in Zambia. Specifically, the study will aim to establish the tax space with focus on domestic consumption taxes (VAT and Excise duties). Tax space can be defined as the amount of revenue that can be collected in Zambia under the existing tax codes and economic fundamentals. The study will establish the tax effort i.e. the ratio between the actual revenue collected and the revenue potential based on the existing laws and provides rrecommendations to address the informal economy in Zambia. In doing so, this report develops an adequate analytical model to evaluate potential revenue and tax compliance rates. It provides recommendation on changes that need to be undertaken at the Zambia Revenue Authority to optimise tax collections. The last but not the least purpose is to present findings to the Ministry of finance, the Tax Policy Unit and provide trainings in order to disseminate skills, knowledge and the use of analytical models employed to assess the tax gaps.

4 Phua, Stephen (2011). Tax Gap: Causes and Solutions 5 See, F Schneider, (December 2004). The Size of the Shadow Economies of 145 Countries all over the World 6 See Dhas & Helen, (July 2008). Social Security for Unorganized Workers in India; and The Task Force for Statistical and

Definitional Issues (2008) 7 See, N Eissa & W Jack, (2010). Tax Reform in Kenya: Policy and Administrative Issues 8 See, C Pastrana, (2010) The Informal Sector and Non-Regular Employment in the Philippines 9 See, World Bank, (2009) Pakistan Tax Policy Report Tapping Tax bases for Development, p 50. The largest contributor to the tax gap was identified to be corporate income tax followed by GST (general sales tax): see p 26.

10 Tuan Le Minh, (2007). Estimating the VAT Base: Method and Application, p. 207 11 See, World Bank (2005). Afghanistan Managing Public Finances for Development

Despite a decade of strong economic growth socio-economic indicators haven’t shown promising improvement in Zambia’s case. President Edgar Lungu is pushing ahead with economic diversification efforts in order to transform the country from one heavily reliant on copper exports to one with highly developed industries across the economic spectrum, including energy, agriculture, infrastructure, manufacturing and tourism. In order to achieve its long-term development goal of becoming a middle-income nation by the year 2030, Zambia has to raise its domestic resource base to meets its growing expenditures. Despite a recent rise in growth and a reduction in inflation, lack of economic diversification, dependency on copper prices (its sole major export), and a large informal sector that remains out of tax net, make Zambia vulnerable to commodity price shocks, exchange rate fluctuations, and a rising debt to GDP ratio (47 percent 2017).

Cost of external government borrowing is increasing whereas investor sentiment continues to fade as evident from the exponential rise in spread on the 2014

Eurobonds that reached 1,375 basis points above US Treasuries. The external debt service is doubling from US$ 720 million (2018 budget) to US$ 1.5 billion (2019). The overall fiscal deficit is programed at

6.5 percent of GDP. The fiscal gap will be plugged largely by external borrowing, which is programmed to increase from US$ 600 million (2018 budget) to US$ 1.5 billion (2019). In the medium term, Zambia plans to:

- attain an average annual GDP growth rate of at least 4 percent

- sustain inflation within the range of 6 to 8 percent

- raise international reserves to at least 4 months of import cover by 2021

- increase domestic revenue to not less than 19 percent of GDP by 2021

- reduce the fiscal deficit to no more than 5.1 percent of GDP by 2021

- prioritize the dismantling of arrears and curtail their accumulation

- reduce the pace of debt accumulation and ensure sustainability; and

- accelerate the diversification of the economy supported by the implementation of structural reforms

In as much as the revenue system is contributing fairly to the national budget, total domestic revenues are not sufficient to wipe out increasing budget deficits in the absence of new strategies. The government is therefore raising the necessary resources domestically with a revenue mobilization of at least 17.7 percent of GDP to finance the growing demand for social services.

The target for 2017 was 18 percent of the

GDP however the actual collection remained just below the target in the first half of 2017 by 8.6 percent mainly on account of lower than expected collections from customs and excise duties, various non-tax revenues and lower grant inflows from cooperating partners. For 2018, tax revenues are expected to be about 57 percent of the total resources (58 percent for 2017).

In the budget 2019 (a total of K86.8 billion), 27 percent is expected to go towards debt servicing with a 21 percent increase in public sector expenditures leaving meagre financial scope for implementing infrastructure development projects. In this scenario, identifying and capturing revenue losses can provide an effective instrument to raise revenues and curb the rising deficit without having to increase the tax rates across the sectors.

12 The GDP grew at an average of 7.4 percent during 2004-2014 and the economy more than doubled in size, however, poverty, unemployment and inequality remained high. After a sharp decline on economic indicators, the GDP resumed growth at 3.4 percent by 2016 and continued to increase – expected for 2018 is 3.9 percent.

13 The quantum of the total public debt burden has increased from USD 9.3 billion from September 2016 to USD12.5 billion by

August 2017. The first payment of USD 750 million towards the Eurobond debt is due in 2022. Zambia plans to refinance

Eurobonds worth $2.8 billion to cut the debt servicing. If Zambia signs up for the IMF bailout package (USD 1.3/USD 1.6 billion), it can spare large sums on external debt-servicing.

14 Tax to GDP ratio declined from19.5 in 1990s to 14.9 by 2016.World Bank data 15 Non-tax revenue of about 11 percent, grants at 3.5 percent, and from borrowing 30 percent)

4. Tax Revenue Performance Zambia has gradually strengthened its revenue collection framework and has introduced institutional reforms, such as the creation of a large taxpayers’ office. Government revenues have improved considerably, from less than Kw 1.0 billion per year before 2008 to Kw 6.6 billion in 2012, which is over

30 percent of total tax collection. Zambia has a considerable wealth of mineral resources and its economy depends heavily on these minerals. Zambia's primary export, copper and copper-related products, account for as much as 77 percent of the country's exports. Among mining countries (excluding petroleum) world-wide, Zambia’s mining receipts were the second highest after Botswana, and bringing higher revenues than Chile, Democratic Republic of Congo or Guinea. In Chile (the highest copper producer and exporter in the world) during 1985-1992 for three years copper taxes represented more than 20 percent of fiscal revenues and more than 10 percent during the other five years whereas in Zambian, during the same period, copper for five years represented 10 percent to 13 percent of fiscal revenues and for several years in Zambia copper provided 3 percent or less of total fiscal revenue. In other words, there were a number of years when copper’s share of fiscal revenue was around 1 percent in Zambia and less than 4 percent in

Chile. Zambia periodically gained copper-based revenues after the year (2000 and onwards), however, after 2014, despite high copper exports, the Government revenues have become lower than the global averages. While natural resource taxes tend to bring in about 25-40 percent of exports for major resource-rich developing countries, they amount to only 3–5 percent in Zambia.

The collection of domestic revenue reached ZMW 30.1 billion in the first three quarters of 2016, against a target of ZMW 31.6 billion. The slight underperformance in domestic revenues was driven by VAT

(below target by 22 percent) and customs and excise (below target by 18 percent). VAT was below target on account of lower collections and higher than projected refund claims, while customs and excise duties were below target due to lower imports. Contrastingly, income tax performed slightly above expectation

(by 1.9 percent) due to improved compliance.

The domestic VAT outperformed the targets in 2017. The ZRA collected K 45,868.2 million in gross taxes (with outstanding refunds of K6,718.5 million) and a net tax collection of K39, 149.7 million (target

K37,622.5 million) registering an outturn of 4.1 percent. Withholding tax and mineral royalty also outperformed targets and were K185.6 million and K544.3 million, respectively. Whereas CIT and PAYE performed the worst and remained below target by K402.2 million and K1, 145.9 million, respectively.

The insurance premium levy was K14.2 million above target, while the skills development levy was

K78.3 million below target. Excise duties were K1, 529.7 million or 32.5 percent below target. Trade taxes namely import VAT, customs duty and export duty were also below their respective targets by

K453.8 million, K210.7 million, and K54.7 million, respectively.

According to the ZRA annual report 2017, the share of VAT in tax revenue increased by 10.3 percentage points to a contribution of 35.8 percent from 25.5 percent in 2016, mainly attributable to the withholding

VAT mechanism which significantly increased the collections of output VAT. On the other hand, the contribution of Income taxes and Excise taxes declined by 9.2 percentage points and 2.3 percentage points, respectively. Domestic VAT made up 40.5 percent of the total net VAT collected in 2017, up from

1.2 percent recorded in 2016. This growth in net domestic VAT collections was mainly due to the implementation of the withholding VAT mechanism.

16 World Bank (Jan 2017). Innovative Solutions for Domestic Resource Mobilization in Zambia

5. The Methodology

A. A Note on Empirical Methods A tax gap is sum of two components: compliance gap (arises from the impact of noncompliance to the provisions of existing laws); and policy gap (arising from the impact of or gap in tax policy). It is important to understand that a tax gap is not an indicator of taxpayer compliance in the short term; it rather reflects on the behaviour of the taxpayers under the existing tax laws at a point in time. Identifying tax gaps can provide means to the ends of achieving an efficient revenue administration and improved tax policy.

A tax gap comprises of three elements: (a) non-filers component (b) underreporting (understating income, overstating deductions) due tax, and (c) underpayment of due taxes. A government needs specific policy program to address each of these elements; for example, broadening of tax base measures would only be effective after identifying specific sectors/taxpayers that are under reporting or not reporting. At the next level, a persistent tax gap would reflect the short-comings in the tax administration. The final level indicates the issues with drafting of the tax laws (which can include compliance costs, complexity of the legal statutes and weak legislations incentivising evasion). There seems to be more scope in improving tax revenues through administrative measures. The World Bank Independent Evaluation Group found in

2017 that policy loans “focused on raising tax revenue through tax administration measures were mostly successful at national and subnational levels; those that supported tax policy to raise tax collection or improve tax efficiency or equity were less successful.

The measurement of tax gap is a difficult exercise due to multiple factors. The key variables that affect the size of tax gaps in a country include structure of the economy, rule of law, politico-economic stability

(most importantly continuity of policies), and tax morality. These are complex variables and are hard to quantify through a unitary approach. To measure tax gap across a specific tax, factors such as type of tax, nature of the economic sector, class of taxpayers, and the quality and availability of data for that country can influence choice of methodology. Similarly, strategies to redress identified tax gaps would also depend on the factors causing such a gap in specific type of taxes and sectors of the economy. For example, if procedural incoherence or complexity of the tax codes is driving the tax gap, simplification of the tax system would enhance tax revenues (and not higher tax rates).

This study aims to identify, estimate and proposes recommendations to mend the tax gaps in Zambia. The recommendations following a three-pronged approach provide specific legal, policy and administrative perspectives. In most empirical studies, tax gap is usually considered a function of poor policies and/ or weak enforcement; however, socio-economic, legal and contextual factors play a critical role in determining the outcomes of any fiscal restructuring. This report reviews tax policy and administrative set up of Zambia, and options to improve by taking into account indigenous socio-political, legal, and institutional factors in providing practical recommendations.

For the purposes of estimating domestic consumption tax gaps in Zambia, this study follows Top-down approaches. In a top-down approach, we use independent statistical data to estimate total potential collections and compare this figure to actual collections. The tax gaps are estimated (in respect of Excise tax and VAT) by measuring revenue potential under the relevant tax codes and contrasting it with the actual revenue collected by the ZRA for that year.

The analytical framework used in this top-down tax gap estimates do not take into account potential price effects, and therefore, creates a static model. That is, it measures the compliance and policy gaps at a given (current) level of consumption, and does not take into account possible behavioural changes due to (future) change in prices, or in tax policy

17 The approach is adapted to an extent from the IMF’s Revenue Administration- Gap Analysis Program (RA-GAP) and has been modified where necessary to (a) suit to Zambia’s context, and (b) availability of relevant data.

framework. The gap estimate is therefore, a measure of current behaviour under the given conditions and indicates efficiency of tax administration and policy, rather than estimating potential additional revenues.

B. A Caveat on Data Measuring precise tax gaps can be challenging due to data limitations both in developed and developing countries. Lack of availability, reliability and precision in the data used to estimate tax gaps in the informal sector (where participants have an incentive to not to report correct information) poses serious observational challenges. To address these known causes (lack of precision in data) and unknowns (size of informal sector), this study uses comparative approach in making an assessment as accurate as possible. The report uses following resources:

Government of Zambia’s statistics (various departments): CSO reports, CSO data (directly provided- published/unpublished), the ZRA (directly provided data, meetings, and published reports), the ZDA website, and Ministry of finance’s various publications.

Various assessment reports conducted by credible local institutions in estimating size of the informal sector, noncompliance to tax laws, and potential revenue losses in Zambia. In certain instances, as specified, this report uses, for comparative purposes, gap estimates from the studies estimating the size of informal (shadow) economy (for example, ZIPAR, IGC) in Zambia, and relies on the extensive work carried out by the GIZ on compliance issues for the SME sector, and uses data processed and published in the various CSO reports.

The report uses comparative regional gap estimates (where available) to contrast revenue performance (if relevant) taking into account tax rates, economic size, and other related variables.

The report also makes use of data provided by external and regional institutions including the

World Bank Group reports, the IMF documents, AfDB and other regional institutions.

This report has primarily relied on the internal documents provided by the ZRA, the Budget office and the CSO. This report uses, in order of priority, data provided by government of

Zambia’s various departments and in case difference in reporting between the external organization’s data values and internal documents, the report relied on the latter.

The primary resources comprise of the various tax Acts as currently enforced in Zambia (VAT

Act, the Customs and Excise Act, Income Tax Act) and the discussions held with the various stakeholders during the mapping mission (Aug 2-14).

Estimating informal sector is challenging task not only in Zambia but in most countries due to lack of reliable data. Informal sector incentivizes workers not to report correctly their incomes or expenditures making it challenging to estimate the size through direct methods. Both direct and indirect approaches have been used in various studies to estimate size of informal economy. Direct methods include:

measurement by the system of National Accounts Statistics, that is, the discrepancy method; micro methods include representative surveys; and, by measuring consumption-income-gap by the households.

Survey sampling is cumbersome, costly and present “reported” data (which may not reflect true income or expenses). Indirect approaches include measuring discrepancy between national expenditure and income statistics; or discrepancy between official and actual labor force. Some studies have used electricity consumption approach; the transaction approach; currency demand approach; and, an adaptive multiple indicators, multiple causes (MIMIC) approach. The selection of particular approach for a specific economy may depend on availability of accurate data, domestic economic and legal structures amongst others. This report uses comparative data from other recent studies (applying various direct or indirect approaches) commissioned by the ZRA and reports by independent agencies estimating the size of informal (shadow) economy (ZIPAR, IGC), and the SME compliance analysis by the GIZ.

II. ZAMBIA: INFORMAL ECONOMY AND REVENUE PERFORMANCE

1. Informal (Shadow) Economy Defining informal economy and its measurement presents both conceptual and real challenges. The concept doesn’t carry a single definition.

In simple terms, informal sector comprises of market based production of all goods and services (legal and illegal) that escapes detection in the official estimates of

GDP.

It includes unreported, unrecorded or non-observed economy associated with the income which is excluded from national income. According to the 2014 Labour Force Survey, 83 percent are employed in informal sector in Zambia while 92.2 percent of people in the rural areas are employed in the informal sector. The CSO reports that the informal sector accounted for 56.1 percent of the informal sector in agricultural-related activities leaving 43.9 percent in non-agricultural activities. In 2010, the Zambia

Business Survey found that only a three percent of the informal businesses surveyed were located in the urban areas of Lusaka and Copperbelt, and resembled the micro-and small-medium enterprise (meetings tax thresholds). However, this survey and other reports find those workers in the informal sector (and not the small business owners) were poor, unskilled, engaged in labour intensive industry due to lack of access to technology, credit, and resources. Similar findings are reported in an IGC study (Kadia Shah

2012) who combines the Business Survey findings with the World Bank Enterprise Survey (2008) and reports that there are about 1.02 million informal micro-and-small enterprises (MSMEs) in Zambia, along with about 30,000 formal MSMEs. This extremely high number appears to offer high taxation potential however; a vast majority of these “businesses” were found very small: less than 8 percent have revenues more than 2 million kwacha (the tax threshold at that time), thus only about 80,000 businesses would qualify for taxation.

Friedrich Schneider (whose work this study quotes) and various co-authors have published extensive work on measuring what they call, “shadow economy” in over 150 countries by employing currency demand approach or a combination of approached termed as MIMIC. There are however issues with the underlying assumptions, data scaling, benchmarking, and more importantly generalizations made across economies (procrustean tendencies). Precise measurement of the informal economy is extremely complicated due to the participants in such economies have an incentive to hide their behaviors; this study relies on bets estimate value. A study on 145 countries estimates that the average size of the shadow economy in developing countries is approximately 40 percent of the official GDP.

In a recent study, Schneider and Medina finds the average size of the shadow economy of the 158 countries over 1991 to

2015 is 31.9 percent. Due to economy-wide recent developments including increased digitalization, documentation, information access, automation, and other local and contextual factors, the size of the informal sector has been on a decline in most of the countries including Zambia over the last two decades.

Table 2: Declining Size of the Informal Economy - Zambia

18 Other terms used to refer to the sector include: shadow economy, black economy, hidden sector, underground economy, parallel sector, second sector, and subterranean economy.

19 Smith, P. (1994). Assessing the Size of the Underground Economy: The Statistics Canada Perspective 20 F Schneider, (2004). The Size of the Shadow Economies of 145 Countries all over the World

Year Size of informal economy

1991 57.14

2000 48.90

2004 47.60

2006 48.52

Source: (Medina and Schneider) IMF WP 2018

Various studies have investigated aspects of…