The OECD has issued a publication on the taxation of small and medium enterprises (SMEs) in OECD and G20 countries. The report examines tax policy and administration in relation to SMEs, noting that these firms generally represent more than 95% of the total number of firms in a country and are therefore important contributors to employment and economic growth.
The general tax rules in a country and special tax measures influence decisions on entering self-employment; the form a business should take; whether or not to incorporate; how to distribute the firm’s income; and investment and growth of the business. The structure of a tax system often incentivizes firms to incorporate and to distribute income in the form of capital where possible. Other features of a system may put SMEs at a disadvantage compared to large firms, for example as a result of preferential tax treatment for interest payments and asymmetrical treatment of profits and losses.
The cost of tax compliance is generally proportionately higher for SMEs than for larger firms, owing to the significant fixed costs involved in complying with regulatory requirements, registrations and returns. These represent a higher percentage of SME sales and income and therefore have an more adverse effect on SMEs than on larger firms
SMEs have found increasing difficulty in obtaining the finance they need for expansion, especially since the financial crisis. The limited availability of debt finance from the banks and other financial institutions and the increasingly difficult terms on which it is offered have negatively impacted the ability of SMEs to finance business growth. They also have to face proportionately greater costs than larger firms in accessing finance.
Governments may support SMEs through tax incentives or non-tax measures such as credit programs. Tax rules to support SMEs include lower corporate tax rates for small businesses or small profits; higher tax deductions, tax credits or exemptions; incentives for the owner or investor in an SME such as tax relief for the initial investment or relief on disposal of the share in the business; and simplification rules such as presumptive regimes.
The OECD study emphasizes that these incentives need to be carefully designed and targeted so as to avoid distortion of economic activity. Distortion can arise for example where a measure provides an incentive for firms to remain smaller or to artificially split into different businesses to obtain the preferential treatment. The incentives should tackle the particular problems for SMEs that have been identified or to support companies that are benefiting the economy.
Conclusions from the study
The OECD sets out various conclusions reached as a result of the study. In addition to the need for careful targeting of the incentives governments need to consider if the size of a business alone is sufficient reason for introducing special rules. If the special rules are considered necessary they should be designed and targeted in a way that does not produce extra compliance costs or distortions to the economy.
The OECD considers there is a particular case for targeting tax incentives or simplification measures to new firms in their first years of business. These firms are most vulnerable to financing and cash flow problems; face barriers to entry and growth through competition from more established businesses; face proportionately the highest compliance costs; and can produce a high spillover effect from innovation. Incentives for these new firms need to be targeted at the particular objective such as financing or innovation.
Incentives or simplification measures should not introduce further distortion by providing incentives to alter economic activity in artificial, distortive ways to benefit from the rules. Preferences can create inequities between different firms depending on their characteristics or an incentive for firms to remain below a particular size.
The incentives should not introduce further complexity through the need for firms to track eligibility, keep specific additional records or spend time choosing between multiple preferences. A simpler general tax system may often be more advantageous in practice than specific incentives. Simplification of processes through the use of IT systems may lower compliance costs and enhance compliance levels.
