Tag: Income

The term presumptive taxation covers some procedures under which the exact income (direct or indirect) is not itself measured but is inferred from some simple indicators which are more easily measured than the base itself.

Presumptive income taxation is employed primarily in economies where ‘hard-to-tax’ taxpayers comprise the majority of the population and administrative resources are scarce. In these countries, most taxpayers lack the financial transparency that allows for effective taxation by the government. The result is that tax administrators estimate or presume the appropriate income on which taxes should be levied.

In developed countries, the transition from presumptive to actual income-based taxation compares to the shift from agricultural to industrial economies. Economic advancements replaced self-employment in farming and small-scale trade with concentrated employment in fewer and larger entities such as governments and large corporations. Whereas tax liability was formerly derived from indices such as estimated crop yield of agricultural produce, it gradually became a factor of actual income received from salary and wages. Movements toward more ‘modern’ forms of tax administration emerged as businesses became more sophisticated and financial transparency increased.

However, in developing countries, presumptive taxation may still be the most appropriate method of tax administration for specific groups of taxpayers. The economic transition from agriculture to industry has not occurred to the same degree as in industrialised nations. Nonetheless, most tax laws are written based on well-defined measures of income and well documented transparent accounting records. The reality is that most taxpayers do not possess the administrative resources to maintain accurate books or navigate complex tax codes.

As a result, tax evasion is rampant and authorities exert considerable effort locating and taxing Small and Scale Medium Enterprises (SMEs), including individuals.

Presumptive taxation can be used for any tax that is normally based on simple accounting records-income tax, turnover tax, and value-added tax (VAT) or sales tax-although it is most commonly used for the income tax. A number of different types of presumptive methods exist in different countries.

Presumptive methods can be rebuttable or irrefutable. Rebuttable methods include administrative approaches to reconstructing the taxpayer’s income, and may or may not be specifically described in the statute. If the taxpayer disagrees with the result reached, the taxpayer can appeal by proving that his or her actual income, calculated under the normal tax accounting rules, was less than that calculated under the presumptive method.

By contrast, irrefutable presumptive assessments are usually specified in the statute or in delegated legislation because they are legally binding. They must be defined precisely. Depending on the situation, irrefutable presumptions might be subject to legal challenge as unconstitutional. In some countries, the constitutional court (or Supreme Court) has been quite active in applying the principle of equality in taxation. Whilst in some other countries, tax law provisions that are seen as denying equal access to justice are particularly vulnerable to constitutional challenge.

Presumptive Taxation is undoubtedly a ‘win-win’ technique given that it is an optimal method of curbing widespread non-compliance without employing excessive government resources because it addresses the concerns of both taxpayer and tax authority. Presumptive taxation provides taxpayers with a simplified option for tax compliance without requiring full financial transparency.

Without a doubt, SMEs employ the majority of taxpayers in any developing country. Yet, many SMEs remain in the informal sector because they lack sufficient resources, administrative infrastructure and accounting sophistication to comply with government tax regulations. The result is that many employers are ineligible to receive the benefits the formal sector offers, which inescapably compromises their financial viability. Small businesses are aware of the advantages that legitimate enterprises enjoy, and most would be willing to pay taxes but for the complexity in the filing process.

Presumptive taxation also offers two additional benefits to both governments and taxpayers: it allows the government to tax its citizens in a more equitable fashion while rewarding efficient businesses with financial incentives. It is generally accepted that wages and salaries paid by corporations and governments are taxed more effectively than income earned by the self-employed due to the introduction of withholding taxes at source. Simplified presumptive taxation schemes increase the probability that the self-employed are also taxed effectively.

Various methods of estimating income and assessing tax liability have been developed by countries that have employed the presumptive income taxation. Some of these methods include standard assessment, estimated assessment, value of land, net wealth and asset value, visible signs of wealth, and minimum taxes amongst others.

Standard assessments assign lump-sum taxes to taxpayers on the basis of occupation or business activity. Standard assessments have shown to broaden the tax base with limited disincentives. Although this method is viewed as less equitable than estimated assessments, it is also less open to corruption. However, estimated assessment is employed as an alternative to standard assessments when taxpayers do not file or are audited.

In the early 1960s, Ghana introduced a simple standard assessment system that fixed lump-sum payments for different economic activities. The payments were established by determining the average taxable income of a few taxpayers selected at random from each class of self-employed taxpayers.

Under the estimated assessment method, each taxpayer’s income is individually estimated based on indicators or proxies of wealth specific to a given profession or economic activity. Key indicators can range from location of property to numbers of skilled employees to seating capacity. France’s Forfait and Israel’s Tahshiv methods both utilised estimated assessments and are recognised as among the most highly developed presumptive tax regimes of their time.

Israel’s Tahshiv method employed objective factors to estimate the income of taxpayers unable to keep records. The Tahshiv for each sector was prepared, often over several years, after extensive research and many visits to a sample of businesses. The average profitability of a particular sector and its relationship to specific factors and indexes were discussed with representatives of the sector before the official Tahshiv was issued. Examples of indicators employed included number of employees, location, seating capacity (for restaurants, cafes, barber shops, etc.), skill level of workers (for carpenter’s workshop or garages), nature of equipment used (for truck and taxi drivers), and water consumption (for ice-producing companies).

Traditionally, the value of land is a known method applied in presumptive taxation. Agricultural output comprises the bulk of GDP in many emerging economies. Yet, with little bookkeeping proficiency and a propensity to cultivate leased land, farmers have few records and can be difficult to trace, epitomizing the ‘hard-to-tax’ taxpayer. As a result, governments that tax agricultural output have adopted laws that assess income based on potential output of land or crop yield, as well as soil quality and productivity ratings. In Nigeria, farming is largely localised and domiciled with illiterate farmers. Thus, the only way to bring them into the tax net is through a simplified presumptive means such as estimating the value of their land.

Factors such as net wealth and value of assets enable income estimation through the comparison of beginning of year with end of year net worth. As one can imagine, it is difficult to determine the amount at the beginning and end of the year with any precision, much less account for expenditures during year. Thus, tax authorities in developing nations such as Argentina, Chile, and Colombia employ this method as a basis for presuming income during audits. However, they are faced with various technical problems when doing so. For example, since it is easy to identify owners of some assets versus others (agricultural land vs. foreign currency) equity issues arise. Moreover, valuation of assets is a problem and presumptions based on net wealth often encourage taxpayers to increase liabilities.

Presumptive Tax Regime is no doubt gaining popularity especially in developing nations. However, there are challenges and obstacles that tend to compromise its effectiveness. Governments that recognize the limitations of presumptive taxation often times include provisions in their tax codes that allow taxpayers the opportunity for a redress. Here are some of the challenges, albeit obstacles that affect the smooth administration of presumptive taxation.

Countries in early stages of economic development tend to employ crude methods of estimating income because they lack the required human capacity to analyse the profitability of various economic activities and to define the indexes for effectively calculating presumptive incomes. As a result, small businesses in particular are routinely taxed unfairly and inefficient.

Arguably, presumptive taxation can help reduce corruption in tax administration. However, the success of presumptive taxation in reducing corruption will depend both on the structure of the scheme and the overall administrative environment and capacity of the tax administration institution. A presumptive taxation scheme can increase the discretionary power of tax officials and in a worst case scenario increase corrupt practices. A carefully designed presumptive taxation scheme can help reduce corruption, but can never be a substitute for the much needed capacity building and administrative reforms within the tax administration.

Overall, presumptive taxation is a form of assessing tax liabilities using methods such as income reconstruction or by applying base-line taxation across the entire tax base. Presumptive methods of taxation are thought to be effective in reducing tax avoidance as well as equalising the distribution of the tax burden.