Reforming the Tax Code

Anyone who follows current affairs in Nigeria knows the gist. Federal government revenue is mostly sourced from crude oil sales. Crude oil price crashes. Federal government promises to reform its revenue sources by focusing on non-oil taxes and so on and so forth. Although we have heard all these stories before it is possible that this time around the FG might actually be serious about trying to re-balance its revenue sources. It is however useful to try to understand why previous attempts to re-balance government revenue sources failed. A big part of this has to do with the tax code. Let’s get to grips with that.

 

First it is useful to categorize taxes into two types; growth taxes (which I will simply refer to as taxes from here) and flat taxes. Note, I made those names up myself. Growth taxes are taxes that grow when economic activity grows. Taxes like the value added tax (VAT) and the corporate income tax (CIT) are good examples. If economic activity grows then sales grow, and if sales grow VAT receipts grow. So VAT revenue is directly tied to growth. CIT works in a similar way. If there are more businesses growing and making more profits, then the corporate income tax grows. So the CIT is linked to growth. On the other hand, flat taxes are taxes that are not directly related to growth of economic activities. Taxes such as right of occupancy fees, or development levies, or “Bicycle, truck, canoe, wheelbarrow and cart fees”. These are typically taxes which are one time fees on activities that have no link to the growth or profitability of the business. In general, the key point is that some taxes are linked to growth while some taxes are not.
So what is the current tax structure. The current tax law gives different branches of government the right to collect different taxes. The federal government has the right to collect custom taxes, corporate income taxes, value added taxes, capital gains taxes from corporate bodies and some others. State governments have the rights to collect personal income taxes from Nigerians only, with the exception of police and military personnel, stamp duties for individuals, right of occupancy fees in urban areas, and a bunch of other levies which mostly count as flat taxes. Local governments have the right to a bunch of levies such as shop and kiosk rates, marriage, death and birth fees, signboard permits and a bunch of other levies that mostly all count as flat taxes. You have probably picked up the general pattern. The FG collects all the growth taxes while the states and LGs collect the flat taxes.

 

A second thing to think about, before we get to the main gist of this post, is the firm structure in Nigeria. Nigeria has a firm setup similar to other countries in Africa. There a few mega-firms and large multinational corporations and then a lot of smaller sized firm, with a large chunk of these firms operating informally. So you have the big identifiable MTNs, and Shells, and Glos and so on. And then you have a plethora of unidentifiable small firms with few employees. We know that these small firms combined make up a significant chunk of the Nigerian economy but individually they are mostly all insignificant.
 

Now back to the FG non-oil tax revenue collection strategies. The focus during times of decline on crude oil revenue is rightly to focus on non-oil revenue. The focus however always appears to be on collecting taxes from the areas which are already relatively well taxed; customs taxes and taxes on the big visible firms. A decline in crude oil revenue is almost always quickly followed by an increase in the revenue targets of customs agencies. Targets which are almost always given to fail as import and exports typically fall when there is a slowdown due to a crude oil price fall. The searchlight also always seems to also be focused on the big and visible firms that are relatively easy targets. The MTNs and the Nestles and co. Although there is nothing wrong with making sure large firms pay their fair share of taxes, it is unfortunate that the section the economy with the most potential for increased tax revenue, the many small firms, are often not taxed. The simple reason is that the FG does not have the capacity to systematically collect and enforce tax collection at that scale. There are simply too many small firms for the Federal Inland Revenue Service (FIRS) to pursue. The FIRS would have to grow to a scale never seen before to successfully implement tax collection from firms in far flung places like Chibok or Faku. And there are not enough McKinsey consultants in the whole of Africa to collect these taxes either.

 

Fortunately, the LGs, and to some extent the state governments, have the capacity to collect these taxes. They have this capacity not because they are smarter or more organized, but because they are everywhere. Every local government area in Nigeria has a local government. From far flung towns in Sokoto to the creeks in Bayelsa. All towns in these areas have local government officials who collect flat taxes. Just not the right kind of taxes. The tax law has resulted in a scenario where only the FG has the right to collect taxes that are actually linked to growth. LGs can only collect flat taxes, most of which eventually turn to rent-seeking taxes that actually hurt growth. Ever heard of a public furniture tax? Ask your local telecoms base station operator. Ever heard of an entertainment tax? Ask your local hotel operator. All these taxes are flat taxes that have to be paid regardless of if businesses are successful or not. And of course businesses being successful does nothing to increase the taxes accruing to the LGs and states The link between business being successful and LGs collecting more taxes is broken. The LG has no incentive to host successful and thriving businesses as all tax revenue flows to the FG.

 

For instance, what happens to the finances of a LG if a tomato paste factory in its area doubles its profits and increases the taxes it should pay from N10m to N20m annually? The impact on LG finances is negligible because all the extra taxes on those profits flow to the FG and will then be shared by all. My calculations may be wrong but LGs get only about 0.03% of taxes on companies in their territory with state governments getting about 0.8%. You read that correctly. That is not 3% but 0.03%. So the local and state governments have no incentive to encourage businesses to grow. Ironically, the rise of these rent seeking taxes is evidence that given the right incentives local government officials can serve as good agents of tax enforcement. What is the way forward? In my opinion the easy option is to establish a link between local and state government finance and the performance of businesses in their domain, and to use these LGs as agents of tax collection for the FG. If the LG agents see direct benefits to their public finances then they would willingly collect and enforce payments of these taxes. There is also the upside that LGs who see a direct benefit to hosting successful businesses will have more incentives to create conditions that allow successful businesses to thrive. The ideal scenario should be to reform the entire tax code although that might be difficult politically. Hello resource control. An easy way out would be to implement the same type of set up as done with crude oil products, where local and state governments get a decent cut on all tax revenue before it flows to the FG for sharing. A 13% derivation on CIT and VAT would be a good place to start. Other ideas welcome.

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