One of the challenges facing African countries in this decade is mastering the dynamics of the

informal sector, which is now emerging as a significant element in African development. The
informal sector which is also known as the shadow economy, forms an important segment of the
African economies and cannot be ignored in attempts to further economic recovery, especially
through improved tax policies. Zambia is no exception.

Researchers who are concerned with the shadow economy not only face difficulties in measuring
it, but also in defining it. This is reflected in the variety of names used to identify it. Some of the
names used are: shadow, informal, hidden, black, underground, gray, clandestine, illegal,
unreported, non-cash, and parallel. The best definition is all currently unregistered economic
activities that contribute to the officially calculated (or observed) Gross National Product.

Smith defines this sector as market-based production of goods and services, whether legal or
illegal, which escapes detection in the official estimates of GDP. It has also been broadly defined
as those economic activities and the income derived from them that circumvent or otherwise
escape government regulation, taxation, or observation.
What then is this tricky informal sector? In layman terms, the informal sector can be defined as
income generating enterprises that operate on small scale using simple skills and are not tied to
any government regulations. The difference with the formal sector is mainly the regulation side
of it. The informal sector mainly operates on small scale on a subsistence level with fewer
employees, though most are really just self- employed individuals. The International Labour
Organization (ILO) thus defines the informal sector as one characterized by ease of entry,
reliance on indigenous resources, family ownership of enterprises, small scale of operation,
labour-intensive and adapted technology, skills acquired outside the formal school system, and
unregulated and competitive markets. There is however need to broaden these definitions to
reflect the reality of many Africa countries.


For developing countries like Zambia, activities that are classified as comprising the shadow
economy include small enterprises and businesses that operate outside the formal economy,
utilize lower levels investment, require less demanding skills, and produce relatively simple
products.

In terms of workforce, small enterprises may employ from one or two persons to ten or more
employees or working family members. Areas, they range from street vendors to small
manufacturing entities, while in rural areas, small enterprises engage in the production and sale
of farm products, handicrafts, and services.


Estimating the size of the informal economy is very difficult because the essence of this area of
economic activity is that people who engage in these activities do their best to avoid detection.
However, studies show that the shadow economy in developing countries appears in many cases
to be much larger than in transitional or developed economies.

Most African countries are losing out on this crucial source of revenue, yet it contributes greatly
to their GDPs.

In the recent past, there have been various debates about the need to tax the informal sector.
Some observers view informal sector taxation as a way of improving the governments fiscal
revenue position.

Others see it as a way of broadening the tax base and distributing the tax burden more equitably.
Both the government and civil society organizations have at one point or another expressed the
need to extend more taxation to the informal sector. These calls are not misplaced as studies have
clearly pointed out that in addition to revenue and equity reasons, taxing the informal sector
increases general tax compliance in the formal sector. What then are the causes of the shadow
economies

The Main Causes of Shadow Economies

Huge tax and social security rules place pressure on small enterprises to operate informally and
outside the official reporting system. The bigger the difference between the total cost of labor in
the official economy and the after-tax earnings from work, the greater the incentive to avoid
incurring labor costs by working in the shadow economy.

Also, increase in the number and nature of government regulations, often measured in the
numbers of laws and regulations like licenses, is another factor that reduces the economic benefit
of participating in the official economy. Regulations lead to a substantial increase in labour costs
in the official economy. But since most of these costs can be shifted to employees, these costs
provide another incentive to work in the shadow economy, where they can be avoided.

Barriers to efficient tax administration
While tax laws impose obligations on taxpayers to contribute to government revenue, the actual
amount of revenues flowing into the hands of any government depends on the effectiveness of its
revenue administration. Weakness in revenue collections leads to inadequate tax collections. For
a number of reasons, efficient tax administration is a major problem in developing countries like
Zambia. Not only do developing governments face an uphill battle in bringing individuals and
businesses into the taxation process, but also face insufficient administrative staff with no skills,
high levels of illiteracy among taxpayers and tax collectors, lack of sufficient computer
equipment and facilities, and lack of reliable statistical data.

Zambia has definitely made improvements in tax policy over the years, but it still lack sufficient
administrative capacity. This has been attributed to numerous barriers to efficient tax
administration. Thus to improve revenue performance, Zambia has to depend highly on
improving tax administration.
A major constraint in tax administration is the lack of adequate resources to sustain and facilitate
the operation of tax authorities. Resources to administer a tax can generally be divided into two
categories: human resources and physical resources. Human resources include not only the
number of tax officials but also the quality of tax officials.

Physical resources cover a wider dimension, ranging from office buildings and office equipment
to vehicles and communication systems.

These are the resources required by the human resources in order to ensure compliance with tax
laws. Due to financial constraints, many tax officials who are hired lack understanding of the tax
laws they are administering, and the concepts of accounting that are essential to analyzing
returns. The problem of inexperienced and unqualified personnel is worsened by lack of
adequate training facilities and opportunities. Most training undertaken in developing countries is
general in nature, and certainly does not correspond with the particular reform strategies that are
being undertaken by tax authorities.

To reduce informality, government must reduce the costs of becoming formal and increase the
benefits/incentives of becoming formal," he notes in an article published in The African
Executive. For instance, firms that become formal increase chances of access to finance from the
formal banking system, allows entrance to higher value supply chains with large formal firms-for
lucrative business."

In its recent publication entitled: Policy Insights into the Taxation of the Informal Sector in
Zambia, the Zambia Institute for Policy Analysis and Research (ZIPAR) analyzed the informal
sector in Zambia, estimating its size and its potential contribution to tax revenues.

The paper indicates firstly that the Zambian informal sector has not been entirely without
taxation. Since 2004, informal sector taxation has been introduced, starting with a presumptive
turnover tax on small and medium enterprises in 2004, a base tax on marketeers in 2005 and an
advance income tax for cross-border traders in 2007

Unsurprisingly, total revenue from these informal sector taxes, as a proportion of total income
tax, has remained sluggish, only reaching a high of 2 percent in 2009. It is this under
performance of revenue that has fuelled the debate on the need to tax the sector more than
currently exists. This of course has been driven by the belief that there exists appreciable taxable
income in the sector and that the sector is currently running away untaxed.
Of course the other side of the debate has not been without proponents. It has been argued that
whatever transactions go untaxed in the informal sector are simply not significant enough to
warrant the cost of collecting.

It is therefore not surprising that the 2012 national budget speech did not propose any new tax
measures on the informal sector. The question which has therefore been begging answers is
whether indeed there exists significant taxable income in the informal sector and how
worthwhile it is to follow this income.

The answer to this question will start to lay a foundation against which future tax policy can be
shaped. Zambias informal sector is quite large. The informal sector is subject to a wide range of
varied definitions, depending on who is looking at it. In part, it is this attribute that makes
measuring its size a challenge. Consequently, there are various methods for estimating the size of
the sector, including so-called direct approaches that use surveys and indirect methods that try to
make estimates based on macroeconomic relationships.

The ZIPAR study (on which the aforementioned publication is based) used an indirect method
called the Currency Demand method in estimating the size of the informal sector in Zambia for
the period 1973-2010. Measured as a proportion of formal sector GDP, informality has averaged
at 47.7 percent per annum during the same period, reaching its peak during the 1991-2000
decade where it averaged 56.3 percent.

As of 2010, the informal sector was as large as 40 percent of GDP. Furthermore, the sector has
been increasing over time at an average growth rate of 2.7 percent per annum (compared
to a 2.8 percent growth rate for the formal sector during the same period).

The amount of tax revenue that is forgone by not taxing the informal sector, assuming zero
collection costs, was calculated at an average of 7.7 percent of GDP. This represents about 42
percent of total tax revenue collections yearly on average.

For the year 2010, the estimated total amount of foregone tax revenue from the informal sector
was 6 percent of GDP or 34 percent of Zambias total tax revenues. But is there any real
potential for informal sector taxation? At a glance, the estimated size of the informal sector and
the amount of tax revenue forgone from the informal sector (or potential tax amount) look quite
appealing. But, if we take into account tax collection costs, the potential reduces. Collection
costs can be significant in this sector, as demonstrated in our assessment of what the informal
sector looks like.

The 2008 Central Statistical Office Labour Force Survey indicates that out of the 4.6 million
employed persons in Zambia, 89 percent (4.1 million) were employed in the informal sector
while the remaining 11 percent (0.5 million) were employed in the formal sector. Of the 4.1
million informal sector employees, 3.4 million basically worked in household-based activities.
Furthermore, of the total informal sector employees, the largest number, 3.2 million, were
employed in the agricultural sector while the second largest at 400,000 were working in trade.
Thus, as of 2008, the informal sector in Zambia comprised over 70 percent of entities which
can be classified as hard-to-tax entities.

These are entities that are also likely to have incomes largely below any feasibly taxable
threshold. Therefore, the most flagrant tax evasion is likely to exclude the bulk of informal sector
participants. Rather, it is associated with small businesses operating close to taxable thresholds.
In addition to this, formal sector activities like free-lancing and moonlighting among a cross-
section of professionals, untaxed house rentals from the growing high end of the housing market,
and so on, are likely to contribute to the most flagrant evasion.

Consideration of the administrative capacity of the Zambia Revenue Authority (ZRA) shows that
the bulk of income tax revenue contributions (about 75-80 percent) come from the large tax
payers though the large tax payer office comprising of about 3.3 percent of total ZRA staff. The
medium taxpayer office is roughly 10 percent of the total number of staff and they manage to
rake in 18-23 percent of total income tax revenue collections. The small taxpayer office has the
largest number of staff, at 14 percent, but only collects a meager two percent. This essentially
means that reaping the potential tax revenues in the informal sector is bound to be a very costly
exercise, enough to wipe out any tax revenue gains so anticipated.

What are the insights for policy? The informal sector estimated at over 40 percent of GDP is
sizable and is typical of most developing countries. Its sheer size means that the informal sector
cannot be ignored in tax considerations. At the same time, the characteristics of the sector mean
that mere attempts of introducing more taxes are unlikely to yield significant net revenue.

Therefore in order to tap into some of the informal sector resources currently escaping the tax
net, a few policy options may be feasible in the short to medium term. Firstly, it will be
worthwhile to fully exploit the personal income tax outside salary income by reducing levels of
non-compliance and improving tax morale. The personal income tax is largely employees tax
deducted at source (that is PAYE). The current heavy reliance on PAYE implies that regardless
of individuals other incomes, tax deducted from their salaries mostly constitutes their total and
only liability for tax. Furthermore, individuals who do not earn income deductible at source may
escape the tax net completely. Good examples of this are freelancing by various professionals
and rental income received by a growing housing market.

Secondly, enhancing incentives for the formalization of small businesses will be an important
pursuit. Government has in the past used deterrent and punitive measures to compel businesses
to register for Income Tax or VAT. For example, the Advance Income Tax (AIT) for traders was
raised from three percent to six percent in 2009 to encourage registration for tax purposes and
increase compliance given that traders opted to remain unregistered even after the introduction of
AIT.

Thirdly, strengthening VAT performance will also be important. Administration of VAT,
particularly domestic VAT, needs to be improved further. As the most broad-based tax in
Zambia, VAT captures some of the transactions of the informal sector when the informal sector
purchases goods and services from the formal sector. Thus, overtime exemptions should be
rationalized and streamlined. In summary, the short-to-medium term measures aimed at
addressing informal sector taxation in Zambia should not call for simply the introduction
of more taxes but rather strengthening existing taxes and channels that foster formalization of the
informal sector.
A tax system concerned to facilitate growth should both reduce the cost of operating in the
formal sector and increase the cost of operating in the informal sector. Imposing higher taxes
on traditional agriculture is usually difficult both politically and administratively and it may not
always be equitable, but it is likely conducive to growth by shifting resources away from the
traditional agriculture sector, a development that always and everywhere accompanies growth
(Bird 1974). Much the same can be said about presumptive taxes on informal sector activities
even though such taxes are often so badly designed and operated that they are horizontally
inequitable and seldom yield much revenue (Bird and Wallace 2004). When countries have large
informal sectors even a bad tax on agood base may be a good idea (Auriol and Warlters 2005).

(iii) it is counterproductive to try to enforce complex taxes such as VAT or income tax on small
and micro enterprises because the costs of collection outweigh the benefits; these enterprises will
pay VAT when they purchase inputs from the formal sector;
(v) opportunities for corruption are pervasive in tax collection; hence a comprehensive anti
corruption strategy, including an effective internal audit function, is essential.
Revenues foregone by tax incentives for investment such as tax holidays, partial profit
exemptions, free trade zones, etc. tend to exceed by a wide margin the revenue costs expected
before the concession is put in place. In particular, countries frequently under-estimate tax
planning opportunities for multinationals to extend the coverage of tax relief to shelter non-
targeted activities and profits. Increased reliance on other taxes and the need for tax base
protection measures place additional strains on the tax system.
At the same time, competition amongst countries to attract mobile investment creates pressure
for continued use of targeted tax incentives. Given this, some degree of cooperation amongst
countries may be necessary to prevent a counter-productive race to the bottom in effective tax
rates on profit, especially amongst those countries linked by free trade arrangements and thus
likely to be in the most direct competition for mobile capital. Arguably, with some form of
regional collaboration, the priority of policy makers should be to limit the most damaging tax
preferences such as tax holidays and export incentives. A monitoring framework and system to
exchange information would be necessary to implement this type of agreement (IMF, 2009).















CONCLUSION
It is undisputable that the far-reaching impact of the expanding informal sector, and the
governments limited capacity for effective tax administration all threaten the productivity and
competiveness of the economy, and reduce the amount of revenue the government can collect.
The government has to make itself more fiscally relevant to everyone in Zambia, and needs to
find creative ways to do so.
Tax exemptions and deductions on essential goods and services benefiting the low-income
population could be introduced. These tax benefits would not only benefit those with low
incomes, but would enable the government to give some of the potential taxpayers who have
been hiding in the unrecorded economy incentives to join the recorded economy.