How to tax small businesses? In recent months, this question has become the centre of heated discussions in Ukraine. The main topic of the discussions is the future of the Simplified System of Taxation, Accounting and Reporting (or Simplified Tax System, STS), which may be reformed as part of the government’s tax reform. To assess the different options for reforming (or not reforming) the STS, it is worth looking at the current state of small business development and the practice of using the simplified taxation.
Current State of the Ukrainian Small Business
Small business in Ukraine is poorly developed, at least the officially registered small business. According to the estimates by experts of the USAID program “Leadership in economic governance” (LEV), in 2013 the share of small businesses in gross value added (GVA) was 19.8% . This was significantly lower than in more developed countries. According to Eurostat, in the EU the corresponding share of small businesses for the same period was twice as large — 39.4%. Regarding microbusiness (which is a part of small business), the difference was even more significant: the share of microbusiness in Ukraine’s GVA was 8.7%, while in the EU it was 21.1%. Thus, the potential of small business in Ukraine is underutilised.
How Widespread is the Use of STS in Ukraine?
The STS is used mainly by the smallest business entities. According to the State Fiscal Service of Ukraine (SFS), 159,500 companies were single tax payers (i.e. used the STS) in 2013. Their share in the total number of small companies was 33.4%. The simplified taxation was also used by 1.3 million individual entrepreneurs, which was about 70% of the total number of individual entrepreneurs.
However, the revenue of single tax (ST) payers was only 30.7% of the total revenues of Ukraine’s small businesses and only 6.6% of the total revenues of all business entities.
What Does the Business Get from the STS?
First, the STS allows to reduce accounting and reporting costs, which is critical for the smallest businesses. Second, it decreases the amount of taxes paid (this affects not all but probably a majority of ST payers). Third, the STS provides protection against abuse by tax officials, which reduces risks and creates more stable conditions for business development. According to LEV experts, in 2013 single tax payers saved the amount of money equivalent to 2.4% of their revenue on accounting and reporting, and the amount saved on taxes stood at 3.9% of the revenue.
What Does the Government Get from it?
In 2014, companies and individual entrepreneurs paid UAH 7.4 billion (EUR 0.5 billion) in the single tax, which was 2% of the consolidated budget tax revenues.
Abuse of the STS?
The simplified tax system can be used for non-intended purposes. First, low accounting requirements facilitate tax evasion through understatement of revenue or wages of employees. Analysis of the distribution of revenue declared by single tax payers provided an evidence for the existence of such an abuse. According to the LEV experts’ estimates, in 2013 the amount of revenue that was not declared by a part of ST payers (by the second tier of single tax payers) was UAH 7.8-13.2 billion, or 14.6%-24.8% of the declared revenue by those taxpayers.
Second, companies can use the STS to save on taxes and social contributions by registering their employees as individual entrepreneurs. According to a survey by the State Statistics Service of Ukraine, in 2013 the number of self-employed people in the legal sector of the economy amounted to 740,000. Given that the total number of active entrepreneurs amounted to 1.8-2 million, one may assume that 1-1.2 million entrepreneurs either combined hired work with entrepreneurial activity or were entrepreneurs only formally. According to the LEV experts’ estimates, in 2013 the amount of such savings on taxes and social contributions was UAH 6.3 billion.
Moreover, the benefits of the STS can actually be enjoyed not only by small businesses but also by medium and large enterprises (via splitting the business into smaller companies, registering employees as individual entrepreneurs, or through the use of ST payers as money converting centres).
Does the STS Promote Small Business Development in Ukraine?
There is no definite answer to this question which is backed by quantitative studies. The STS promotes the development of those business entities that use it (see the answer to question 3), but can create barriers for small business development in general. As the study of a similar taxation system used in Mexico (Repecos) shows, an essential part of small businesses avoid growing beyond the size that allows them to use simplified accounting and save on taxes .
Besides, different levels of taxation may distort competition and impede productivity growth. The co-existence of different tax regimes disrupts competition mechanisms and thus may hinder the development of businesses that have to pay more taxes – that is, those businesses that use the general taxation system. The number of such companies is less than the number of STS users, but their role in the small business is bigger. As mentioned earlier, in 2013 the share of single tax payers in the total revenue of small businesses was 30.7%.
The role of small business in the economy of Ukraine did not increase significantly after the introduction of the STS. In 1999, the share of small companies (not including individual entrepreneurs) in the total revenue of Ukrainian enterprises amounted to 11.9%, and in 2013 it was 16.5%. However, it is impossible to compare these figures directly, since in 2013 a broader definition of a small business was used (in 1999, this definition covered enterprises with the revenue up to EUR 0.5 million per year, in 2013 – up to EUR 10 million per year). The share of individual entrepreneurs in the total revenue of the business entities in 2013 was 6.6%; the 1999 data is unavailable to public.
According to the State Tax Administration data published in 1999, as of October 1, 1999 there were 750,000 active entrepreneurs in Ukraine. This roughly corresponds to the number of people who worked as independent contractors in the legal sector of the economy in 2013 (see the answer to question 5). However, these data cannot be interpreted as an evidence of failure of the STS. The small business development in 1999-2013 was influenced by many other factors, both positive (economic growth) and negative (unfavourable regulatory environment, political instability).
Is It Necessary to Reform the STS?
Reforms are needed, but they should be considered in a much broader context than the simplified tax system reform. If the tax treatment of single tax payers is close to the general taxation system in its present condition (given the unsatisfactory tax administration practices), the overall result is likely to be negative.
It should also be borne in mind that the simplified tax system reform is a politically difficult process, because it affects interests of a majority of entrepreneurs. Therefore, any reform in this area should be well thought, balanced and accompanied by an explanation of benefits that entrepreneurs and society will receive as a result of the reform. Given this, changes in taxation of small businesses should be part of a broader reform package which should include simplification of accounting requirements imposed by the general tax system, increased transparency and elimination of abuse of public funds, improvement of the quality of public services (law enforcement etc.), activation of antitrust policy, as well as significant improvement in tax administration.
The article was originally published on November 3, 2015 in “Business” newspaper (in Ukrainian) http://www.business.ua/articles/ukraine/sproshchena_sistema_opodatkuvannya_zapitannya_ta_v_dpov_d-267190/
1. Betliy О., Burakovsky І., Kravchuk К. Simplified tax system in Ukraine: assessment in the context of current realities. Report prepared in the framework of the USAID Program “Leadership in Economic Governance” (LEV). Kyiv, 2015.
2. Claudia Sánchez-Vela, and Jorge N. Valero-Gil. “The Effect of Firm-Size Dependent Policies on the Economy: The Case of the Repecos Law in Mexico.” IDB Working Paper Series, February 2011.