Taxing the informal sector

The defining tax problem of African states is that most economic activity happens outside the formal, recorded, taxable economy. 80–90% of employment is informal. This module asks how — and whether — to tax it, a question where the easy answer (just tax everyone) collides with administrative reality and the right answer is genuinely contested.

Why the informal sector is hard to tax

• No records — informal firms keep no accounts, so there is no income or turnover figure to tax and nothing to audit against.
• Cash and mobility — transactions are in cash (or, increasingly, mobile money), leaving no automatic paper trail, and traders can relocate or disappear.
• Small and numerous — millions of tiny units, each yielding trivial revenue, so the administrative cost per shilling collected is enormous.
• No withholding agent — the formal economy is taxed largely through employers and banks who withhold and report; the informal sector has no such third party to deputise (the master tool of administration, next module, is missing).

Presumptive taxation

The threshold and the notch

Presumptive regimes sit below the VAT/standard-regime threshold, creating a deliberate two-tier system: simple presumptive tax for the small, full regime for the larger. But thresholds create notches — sharp jumps in tax liability at the boundary — which firms respond to by bunching just below (staying small, splitting into multiple firms, or under-reporting to avoid crossing). Empirical work (e.g., Onji on VAT splitting) shows real bunching at thresholds. Designing the transition — phasing in the full regime rather than a cliff-edge — reduces the distortion and the incentive to stay sub-scale, which matters because you do not want the tax system itself discouraging firms from growing.

Is it even worth taxing?

Here the experts genuinely disagree. The skeptical case (Keen and others): the revenue from the informal sector is small (the truly poor and tiny generate little), the administrative cost is high, and chasing it can be coercive and regressive — better to focus scarce administrative capacity on the large taxpayers who account for most revenue. The case for taxing anyway rests less on revenue:

• Equity and morale — formal-sector taxpayers resent carrying the burden while visible informal traders pay nothing; a presumptive tax sustains the perceived fairness that underpins voluntary compliance (tax morale).
• State-building and the fiscal contract — bringing citizens into a tax relationship, even a small one, can build the accountability link between taxpayer and state (the Governance and final-module theme): people who pay tax demand more of government.
• Formalisation and growth — registration for tax can be a gateway to formalisation (credit, contracts, courts), though the evidence that taxing the informal sector promotes growth is weak and the causality may run the other way.
• The honest synthesis — the case for taxing the informal sector is mostly about equity, morale, and state-building, not revenue; design it to be cheap, simple, and light, and do not expect it to fill the budget gap (the large-taxpayer base does that).

The digital handle

Mobile money and digital platforms have given administrations a new way to reach previously-invisible activity: a digital chokepoint. Kenya's mobile-money excise, digital service tax, and the broader move to tax digital transactions are attempts to tap informal and digital activity at the point where it becomes electronically visible. The appeal is administrability (a few operators withhold automatically); the danger (from the first module's exercise) is efficiency and equity — taxing the very technology that is pulling people toward formality and inclusion, and falling on the poor who transact in small amounts. The digital handle is real but double-edged, and a transaction tax is a blunt instrument for reaching informal income.