DETERMINANTS OF TAX COMPLIANCE AMONG SME’s
CHAPTER TWO
REVIEW OF RELATED LITERATURE
2.1 Introduction
Most large companies have their roots in small and medium enterprises suggesting that the future large corporations are the SMEs of today that that must be nurtured to ensure their growth. Thus, SMEs are generally perceived to be the seedbed for indigenous entrepreneurship and generate all the many small investments, which would otherwise not have taken place (Aryeetey & Ahene, 2004). Therefore, developing economies like Nigeria needs to further the development of its private sector by creating an environment favorable to the growth of SMEs, strengthening the factors that lead to business success, and addressing the problems threatening the existence and advancement of small and medium enterprises (Chu, Kara & Benzing, 2008), so they can adequately play the role expected of them in economic transformation. Such role includes mobilization of domestic savings for investment, appreciable contribution to gross domestic product, increased harnessing of local raw materials, employment generation, and significant contribution of poverty reduction efforts through sustainable livelihoods and enhancement in personnel income, technological development and export diversification (Smatrakalev, 2006). Furthermore, they have the advantage of reaching the farthest corners of the country unlike the larger establishments. For this reason, an ideal tax policy needs to be adopted in order to ensure voluntary compliance, economic growth and proper utilization of resources rather than suffocating the entrepreneur initiative they are out to cater for. It is a well known fact that the revenue generated from the taxation of individuals and businesses is an important stream of income for government. In an economy like ours that is struggling to remain afloat, it is even more important. Tax revenue is the source of funds used for development projects such as provision of infrastructure like good roads, stable power supply, stable water supply etc. All of which combine to create an enabling environment for businesses –and in turn the economy at large- to grow. Small and Medium Enterprises being profit generating establishments are also expected to pay their dues. The important question however is “how much tax should they be levied”. Small and medium enterprises are volatile establishments that need special treatment. Putting their nature into consideration, every little resource at their disposal can make a world of difference. For this reason, a number of Nigerian SMEs choose to remain in the informal sector because they feel the cost of compliance is too high. And a considerable number of those who pay only do so because they are coerced by the authorities. Since the individual SME pays a very small amount of tax compared what the larger establishment would pay, tax authorities tend give the larger corporations more attention. This means a good number of SMEs get away with not paying their taxes hence revenue that would otherwise have been invested in development projects that will end up being of benefit even to the SMEs is lost. This therefore is a situation that needs to be corrected. The above brings to light reasons why the issue of taxation of SMEs is really important. First, tax provides revenue for the government to create an environment that will ease the running of all businesses SMEs inclusive. At the same time if an SME is faced with high compliance costs, it has a tendency to avoid paying taxes hence; the revenue that would have been used to create this environment is diminished thereby reducing the SME’s chances of survival.
2.2 THEORY OF INDIVIDUAL CHOICE
As per the research study by Allingham & Sandmo (1972), in regard to the Basic theory of Individual Choice, if a person receives a particular sum of revenue, there is an obligation for the purpose to choose what portion of the revenue to termed as going to the tax authorities as tax, and also how much to out rightly under report. This method provides the practical outcome that compliance majorly does depend on enforcement. Nevertheless, it is vitally important to realize that an individual pays taxes for no other reason but for fear of being punished upon detected as being non-compliant. From the foregoing, the implication per the guidelines of this theory is that rational persons would simply file no taxable income. In this context, a rational individual refers to a utility of maximizing evasion of tax, considering both the advantages of successfully deceiving the tax system and the dangers of being punished once detected of the cheating, and for this reason the individual will honor the tax compliance requirements for fear of being penalized. Needless to say, compliance amongst individual payment of tax has sustainably remained high over the years. Analytically, there is no support that enforcement by the relevant authorities could be responsible for making individuals comply. The ultimate idea with tax compliance is why less tax is paid than expected, not why tax payers evade paying taxes due
2.3 ECONOMIC DETERRENCE THEORY
This theory, also known as deterrence theory, holds that behavior of tax payers is impacted by factors such as tax rate that determines the threats that may come with evasion, and also the likelihood of being detected upon evasion and what penalties one may face as a result of Allingham and Sadmo (1972). 8 Persuasive measures and also punitive measures can be combined to achieve deterrence. Measures such as increased chances of detection for evaders, increasing tax rates for noncompliers, and an imposition of tighter penalties. Alternative methods could include properly educating the tax payers, increasing publicity and the associated incentives. In economic terms, a tax payer is taken to be a person of upright morality who finds any ways to evade tax payment with an aim of maximizing their utility. The model suggest that tax spenders play an audit lottery, that is, they perform computations of economic significances of varied obedient alternative, like whether to evade tax or not; the prospect of being detected and penalties that may accrue, and they select the alternate that make the most of their after tax earnings or proceeds. The concept suggest that tax payers are moral utility maximizers, hence the stress on augmented inspections and punishments as a resolution to compliance challenges. Monetary founded studies be certain of that tax payers’ behaviour is subjective to monetary motives like enlargement of profits and likelihood of being detected (Trivedi & Shehata, 2005).
2.4 SOCIAL INFLUENCES BEHAVIOR THEORY
Tax acquiescence factors from a communal standpoint related to taxpayers’ inclination to conform with tax regulations in retort to many other popular behavior and the situation of their community (the direction, associates and family level members) (Torgler, 2007). Kirchler (2008) recommended, on the other hand, that societal features need be observed in a wider sense than the standpoint held by Torgler (2007); this comprises the taxpayer’s mindset. The influences deliberated herein are thus integrities and insolences inclined to tax agreement, acuities of fairness and equity, and also modifications on the present administration policies and the referent groups. The theory of planned behavior advices that the primary influence in defining if an individual will engross in particular behavior is the purpose to execute the behavior itself; the larger the purpose to accomplish the behavior, then the more probable an individual is actually engaged in the behavior. The theory of planned behaviour also articulates that there are three main influences that are connected with the person purpose to perform. These factors are; a person’s attitude in the direction of the behaviour in question, societal factors and apparent behavioral control. Social standards are how humanity impacts a person’s behaviour. Perceived behavioral control deals with the quantity of control nn individual trusts he has on a particular action.
2.5 FISCAL EXCHANGE THEORY
The existence of government spending inspires individuals to observe the prevailing tax regulations. This is only conceivable if the government provides its people with public properties and services in a more well-organized and reachable manner, Cowel & Gordon (1988). Consequently, taxpayers are thus largely and by far concerned with what they directly get in from the government in return for their tax obligations in the nature of communal goods and amenities. It is in this respect, that taxation and delivery of public goods and services that generates a contractual association between the tax payers and the government. Lewis (1982) proposes that taxpayer attitudes ought to have proper inspection for the extent to which they emanate from of mythology and misunderstanding. He contended that when mythologies and improper perceptions are substituted with factual information, a transformation in the taxpayer attitudes in the direction of taxation and compliance will ensue even if the fundamental ideology of the taxpayer and the associated values continue unaffected as well as the tax laws. He also outlined that misunderstanding undoubtedly plays a major role in determining impartiality and assessments. In close relations, Roberts, Hite and Bradley (1994) as well advocate that attitude on a person’s own tax avoidance (ethics of tax), and attitude regarding to other persons’ evasive behaviors are significant. If the administration is intelligently utilizing the state income, for instance for primary amenities like health, electricity, health and security and public transport, it is prospective the intensity of compliance on voluntary basis will increase. In disparity, if taxpayers recognize that the administration spends much on services regarded as superfluous or unprofitable to the taxpayer, there will be the tendency to hold the impression of being deceived and attempt to fail to comply. Summarily, the administration should discreetly use taxpayers’ money since the manner the administration uses the money brings varied degrees of compliance. Taxpayer’s insights are hypothetically imperative in defining their compliance behavior
2.7 DETERMINANTS OF TAX COMPLIANCE
Jackson and Milliron, (1986) identified three main individual features for an existence in association between tax compliance and age, gender and education. According to Fischer’s 10 (1992) model of tax compliance he suggests that demographic variables indirectly impact the taxpayer compliance by their effects on non-compliance chances. There is a constructive link between age of a tax payer and compliance as testified by Jackson and Milliron, (1986). An investigation conducted by Andreoni et al (1998) from the tax payer compliance measurement program showed that noncompliance was expressively less common ad of lower magnitude among families in which either the head was over the age of 65. In general, young tax payers are willing to take more risks and consequently less subtle to sanctions. Traditionally, women have been recognized as being more conforming to rules, moral limitations, and more conventional life arrangements Jackson and Milliron, (1986). An experimental research conducted by Baldry 1987 also established that females mostly incline to be more tax compliant than their male counterparts. Nevertheless, a study by Houston & Tran (2001) designated that an advanced part of tax evasion was done more by women than men Education recounts more to the tax payers’ aptitude to understand and observe the existing tax laws, Jackson and Milliron, (1986). In a study conducted by Chan et al (2000) exposed that taxpayers with high levels of education proved that there is a high connection between high direct linkage to an improved prospect of tax compliance. By use of a randomized response procedure for a mail questionnaire survey in Australia, Houston & Tran (2001) established out that taxpayers who do not have tertiary education incline to having lower percentages of tax compliance in comparison to their counterparts having tertiary education.
2.8 SOCIAL FACTORS
In a taxation system that is principally on compliance at will, the typical ethics of the taxpayer is increasingly valuable. The degree of moral behaviour is profoundly dependent on how persons recognize the behavior under consideration (Ajzen, 1988). Various research studies on tax psychology forecasting on the behavior of people’s by an application of the Theory of Reasoned Action (TRA) and Theory of Planned Behaviour (TPB) was first presented by Fishbein and Ajzen(1975) and Ajzen (1991). They are theories that endeavor help in the prediction of people’s behavior constructed on the basis of their purposes. It is presumed that moral ethics inspire persons to respond in accordance to them, and that and a taxpayer who views tax compliance negatively will most likely be less compliant (Kirchler, 2008). Trivedi and Shehata (2004) established a noteworthy though a weak connection 11 between evading taxes and ethics. Attitudes and moral principles affected tax compliance behavior from the perspective of their psychological modelling of compliance to taxation. Roth (1989) recognized two fundamental influencing elements in taxpayer taxation compliance, namely self-interest on financial bases and moral obligation. Persons conform to laws of tax since on a personal point of view, it is in ones’ financial interests to curtail their bills of tax, but also for purposes of their conceived moral responsibility to obey tax laws. Roth (1989) confirms that there was a reliably positive association between ethical obligation and compliant behavior. Roth (1989) findings seems to speculate that ethics positively impacts behavior of compliance, to some extent than financial self-interest does. In regard to justice, a person is mindful about their actions fairness, and needs to be handled relative to his virtues, needs and efforts (Kirchler, 2008). If he thinks that own tax mandate is a liability greater than to other individuals inside an income cluster as his, this compliance to possibly declines more extensively at levels associated with group; taxpayers desire an impartial handling of their group category in relation to other income groups. From the societal perspective, compliance to tax minimally likely to be effective if the insight members of society perceive the system as biased; evasion of tax on a wide scale is probable to happen (Allingham and Sandmo, 1972). On the contrary, if the society views the tax system as being impartial and fair, levels of compliance on voluntary basis are anticipated to proliferate.
2.8 ECONOMIC FACTORS
Economic models of nationwide compliance resolutions offer either varied forecasts of the result of the marginal compliance rates; or forecast that augmented rates of taxation would raise compliance (Allingham and Sadmo, 1972). Contrary to this observation, most experimental studies conclude that high taxation rates diminish compliant behavior or offer varied results. Slemrod (1988) concluded that marginal tax rate significantly impacts on underreporting while Kirchler (2008) found that tax rate has negligible impact on tax evasion and underreporting. Estimating the justice of taxation nevertheless entails all-inclusive acquaintance with the right information and a correct interpretation of national tax laws, as well as and compound rates of tax configurations like taxation on progressive basis, that are not flawlessly known to the tax payers. The payers of tax likings for a liberal, uniform and reverting taxation relies on the nature of the particular rates of taxation are accessible, for example, if these taxation rates are termed as nonconcrete content or in tangible terms by providing concrete samples of hypothetical nature. 12 Government spending can encourage compliance. This way, governments could enhance compliance through provision of goods that the people favor in a more effectual and manageable procedure (Cowell and Gordon, 1988). According to Alm et al. (1992), the level of compliance grows with insights of the accessibility of public commodities. Consequently, the foremost concern of taxpayers is what form of goods and serves come from the administration in response for taxes paid. From this viewpoint, taxation by the government and the delivery of public services and goods are understood to be an association that is contractual in nature (Moore, 2004). Persons may honor tax payments since they deem the goods affixed by the government as valuable, identifying that their tax paying is necessary in order to assist the financing of the service and goods delivery and also to motivate others taxpayers to consider contributing (Fjeldstad and Semboja, 2001). Because of the presence of constructive benefits that might enhance the likelihood that persons will conform to payment of tax voluntarily, deprive of undeviating coercion. Even though majority of taxpayers are unable to evaluate the precise worth of government’s services and goods received in response to paid taxes, it is sufficient to content that these tax payers have overall impression and attitude regarding own terms, as well as terms of others in relation to the way they trade with the administration (Richupan, 1987). For this reason, it is sufficiently reasonable to make the assumption that taxpayers’ behavior to comply is significantly affected by the levels with which they are satisfied or not satisfied with the trade terms between them and the administration. As such, if the tax system is viewed as biased or unfair, evasion to tax might, partly in the least, be termed as a mechanism by the taxpayers to regulate their terms of trade with the administration.
2.9 TAXATION OF SMES
Fiscal policy is one of the main components of macroeconomic policy and its tasks have been considered in a double context: first, the core of fiscal policy, and second, the consistency with the monetary policy (Holban, 2007). In general terms, the choice of tax policy to employ depends on the use of one or both two groups of instruments; the first one being the use of special tax preferences and the other incentives to support start-up and growth of small companies. The incentives include the lowering of corporate income tax rates, special tax exemptions and relieves for small businesses. The fundamental purpose of taxation is to raise revenue effectively, through measures that suit each country’s circumstances and administrative capacity. In fulfilling the revenue function, a well designed tax system should be efficient in minimizing the distortionary impact on resource allocation, and equitable in its impact on different groups in society (Bolnick, 2004). It is important that the country’s situation is properly analyzed before employing any tax policy in order have a properly working tax system because according to Slemrod, J. (n. d) Many of the difficulties with the tax authorities are the consequence of poorly conceived tax policies and a lack of certainty regarding future policy changes. The objective of a tax policy should be to achieve collection cost savings while minimizing the revenue loss, disruption to the economy, and the inequity and capriciousness of the tax burden. For an economy such as Nigeria that is still in the throes of a recession, the tax regime must be versatile enough to encourage savings, stimulate investment and reward social responsibility and research funding. To widen the tax net, policy makers must never forget the urgency to provide infrastructure; create jobs and reduce unemployment; expand the productive sectors of the economy; stimulate exports, and substantially raise public revenues from non-oil sources (Punch, 2010). Hence, tax policies should aim at bringing all taxable adults into the tax net with a graduated rate that should ensure that the well-off pay their own share while the low income earners are given savings-enhancing incentives. An effective and efficient tax administration system is integral to any country’s well being, it is as a result of this that Baurer (2005) believes that the tax administration must provide an even playing field for business by ensuring that all taxpayers meet their tax filing and paying requirements The tax administration must balance its educational and assistance role with its enforcement role. The rationale behind the whole system of tax is consistent with two of the three major theories of tax namely; the Ability-to-Pay Principle and the Equal Distribution Principle. These two principles stress equality and fairness. While the Ability-to-Pay talks pushes that individuals should be levied taxes based on their ability to pay, the Equal distribution Principle suggests that income, wealth, and transaction should be taxed at a fixed percentage; that is, people who earn more and buy more should pay more taxes, but will not pay a higher rate of taxes (Gabay, Remotin, & Uy, n.d)
2.10 TAX COMPLIANCE AND SMES
According to Marti (2010) tax compliance is a complex term to define. Simply put, tax compliance refers to fulfilling all tax obligations as specified by the law freely and completely. It has been found that regulatory burdens fall disproportionately on small and medium enterprises internationally (Pope & Abdul-Jabbar, 2008). Their size and nature makes the issue of tax compliance one of particular importance especially since most SMEs have access to limited resources and inadequate expertise to comply with diverse and complicated regulation. He also believes that high compliance costs can result in tax avoidance, tax fraud, and inhibit investment by way of diminishing competitiveness of the country in terms of taxation attractiveness. Tax non-compliance may be in one of many forms; it could either be failure to submit a tax return within the stipulated period or non submission, understatement of income, overstatement of deductions, failure to pay assessed taxes by due date. (Kasipillai & Abdul Jabbar, 2006) and in some cases non-compliance may mean an outright failure to pay levied taxes. Studies have shown that the problem of tax evasion is a widespread one (Kasipillai & Abdul Jabbar, 2006). Furthermore, Fagbemi, Uadile & Noah (2010) found that it is prevalent in developing countries and it hinders development thereby leading to economic stagnation and other socio-economic problems. Chipeta (2002) identified tax rates as one of the causes of tax evasion. He pointed out that a higher tax rate increases taxpayers’ burden and reduces their disposable income therefore, the probability of evading tax is higher.
2.11 EMPIRICAL REVIEW
There are numerous empirical research studies on compliance rates to tax with evidence being drawn from many parts of the world mostly developing economies. Mostly have focused on relating how various factors that have an influence on tax compliance affect the tax com 13 payments and compliance could be beneficial in investigating if the attitudes have a connection with personal primary political attachment. Hasseldine and Hite’s research study evaluated two impending impacts on attitudes of the taxpayer, namely affiliation to parties of politics and attribute framing. Because the attitudes relating to tax might be predisposed by personal inclinations to a political party, attitudes of taxpayer regarding the prevailing system of tax are examined for variations by affiliation to a political party. Hasseldine and Hite (2003) resolved that first, political party attachment does have a noteworthy effect on the behaviour of taxpayers; moreover, the more narrowly recognized the provisions of tax are to a particular political party, the great positively it will be acknowledged by affiliates of that party in relation to taxpayers affiliated to other political parties; further, the strategy amendments inclined to be regarded positively by taxpayers; producing a rise in taxpayers confidence and in unforced compliance, and those who perceived it positively also tended to recognize the existing system as being fairer. In conclusion it was obvious that government resolutions and changes to strategies in accord with the economic and political state have a noteworthy influence on compliance. For instance, an affirmative move by the administration like tax rebate incensement is probable to enhance taxpayers’ compliance. Wandugu (2014) in his study on the effects of electronic taxation on the financial performance of audit firms in Kenya. He was able to identify that tax evasion was still a great concern in Kenya. There was great concern on the competitiveness of tax in Kenya being low even after the review of tax revenue performance as well as the ta design and administration changed which happened in the period of 1996-20005. Within Kenya firs were reporting about 68.2% of their profits were taken away in terms of taxes hence the low tax competitiveness leaving Kenya as one of the most tax unfriendly countries in the world. Tax evasion was still high with a tax gap of about 35% and 33.1% in 2000/1 and 2001/2 correspondingly. The tax code is still multifaceted and burdensome; categorized by uneven and partial taxes; a thin tax base with very high tax rates and rates distributions with respect to trade, and little compliance. Further difficulties comprised tax structures with rates and systems that are problematic administering, as well as and complying with; which is insensitive to growth and discretionary policy for this reason low levels of productivity; generate small amounts of revenue but present serious fiscal alterations; treat labour and capital in alike conditions variedly; and are discerning and askew in approval of those with the capability to conquest the tax government and implementation system. P. Magutu & Lumumba et al (2010) in their tax payers’ attitudes and compliance behavior toward tax in Kenya study sought to identify tax payers’ attitudes towards the systems of 14 taxation and the factors that impact tax payers’ attitudes and sought to establish the association between tax payers’ attitude and tax compliance behavior. Their research involved a survey of two hundred and sixty taxpayers from the small and medium sized enterprises in Kerugoya town. Descriptive statistics was used for data collection and presented in the form of proportions, graphs and tables. The researchers concluded that majority taxpayers viewed the Kenyan tax system as unfair. However, most tax payers had complied with possession of PINS and had filed their tax on time before 30th June, a sign that they had complied with the deadline provided by the Kenya Revenue Authority, though they did not use the help of accountants or tax consultants. Some factors behind tax noncompliance were established to be; the incapability to comprehend the laws of tax, thoughts that the amounts taxed are not the fair share to be paid, peer attitude. It was discovered that there was a strong connection between tax payers’ attitudes and tax compliance in Kenya with a correlation of 0.846. Helhel & Ahmed, (2014) conducted a study on elements impacting attitudes on and compliance to tax: A survey study of Yemen. Their aim was to bring about the influence of attitudes and considerations of individual tax payers on tax compliance in Yemen while taking into consideration the internal and external factors. The study was conducted in Sana’a the capital city of Yemen to evaluate and rank the factors that reduce tax payers’ compliance rate. A questionnaire was designed use of a five point Likert scale and distributed to tax payers so as to learn their opinions. The results indicated that high tax rates and partial tax systems were the two major factors related to low tax compliance rate. Furthermore, there was insufficient tax audits, little deterrent effects of tax penalties and tax amnesties. It was also revealed that the tax collected did not give as much return with the delivery of public services and goods. Comparison on the response made based on gender, females were found to be more compliant compared to their male counterparts.