Compliance of Local Authority Tax by Small and Medium Enterprises (Smes) in Nairobi

COMPLIANCE OF LOCAL AUTHORITY TAX BY SMALL AND MEDIUM ENTERPRISES (SMES) IN NAIROBI

(Case of Single Business Permit within Kasarani Constituency)

By
CAMERON KAGEHA

KMU/EMBA/550/2002

ABSTRACT
For decades, tax researchers have investigated why some people pay taxes and others do not. Through experiments, random surveys, and available tax databases, researchers have identified characteristics of noncompliant taxpayers and factors that motivate tax compliance both from economic and behavioral perspective. We add to this stream of research by adopting tax administration efficiency and institutional capacity approach to explain factors affecting compliance of the Single Business Permit Tax by Small and Medium Enterprises (SMEs) in Nairobi’s Kasarani Constituency, a jurisdiction within City Council of Nairobi.

The theoretical underpinning on tax compliance and related factors are extensively covered in the literature review. The review indicates that majority of the studies have adopted both the economic and socio-behavioral schools of thought to explain tax compliance but have failed to incorporate the revenue authority’s institutional capacity. This gap forms the background for the conceptual framework.

The researcher will adopt descriptive survey method in conducting the study. Stratified sampling technique will be used to sample the population of the study. The target population will consist of 8000 SMEs. Stratified random sampling technique will be used to select a sample of 80 respondents. A pilot study of 10 respondents will first be done.

Questionnaires will be the main data collection instrument for the research. The questionnaire will have both open ended and closed questions. Data will be collected through drop and pick later method. Data analysis will be done using descriptive statistics (frequencies, mean and percentages) in Statistical Package for Social Scientists (SPSS) programme to identify the factors that affect SBP compliance by SMEs.

Table of Contents
Title………………………………………………………………………………………...i
Abstract ii
Table of Contents iv
List of Tables and Figures vi
List of Abbreviations vii
Definition of Terms viii

CHAPTER ONE: INTRODUCTION 1.1 Background information 1 1.2 Statement of the problem 4 1.3 Objectives of the study ………………………………………………..............5 1.4 Research Questions 6 1.5 Significance of the study………………………………………. 6 1.6 Scope of the study 6

CHAPTER TWO: LITERATURE REVIEW 2.1 introduction 8 2.2 Concept of Tax Compliance 8 2.3 Factors Affecting Tax Compliance 8 2.3.1 Tax Procedures 8 2.3.2 Incentives 10 2.3.3 Computerization of Tax Administration 11 2.3.4 Tax Education 12 2.3.5 Tax Sanctions 13 2.4 Empirical Literature on Tax Compliance 14 2.5 Summary and Gaps to be Filled by the Study 15 2.6 Conceptual Framework 16

CHAPTER THREE: RESEARCH METHODOLOGY 3.1 Introduction 18 3.2 Research design 19 3.3 Target population………………………………………………… 19 3.4 The Sample design and Sampling Technique…………………………………. 20 3.5 Data collection ………………………………………… 20 3.6 Research Procedures…………………………………………………………….20 3.7 Data analysis and Presentation…………………………………………………..20 3.8 Variable definition…………………………………… 20

References………………………………………………………………………………..21
Appendix i: Research Work Plan………………………………………………………25
Appendix iii:Questionnaire………………………………………………………………26
Appendix iv:Single Business Permit (Kenya Gazette 1999)………………………….....32

LIST OF TABLES AND FIGURES

Table 1.1: Revenue from SBP………………………………………………… 4
Table 3.1: Target Population…………………………………………………… 17
Table 3.2 Sample Design……………………………………………………… 18

Figure 2.1: Conceptual Framework ……………………………………………. 16

LIST OF ABBREVIATIONS

SBP : Single Business Permit
NCC : Nairobi City Council
LA : Local Authority
SME : Small and Medium Enterprises
SPSS : Statistical Package for Social Scientists
LATF : Local Authority Transfer Fund

DEFINITION OF TERMS
A loss of welfare: occurs if there is a way to allocate the same resources in a way that makes a taxpayer better off. For example, in the context of tax evasion, a taxpayer would be made better off by receiving the expected gain from tax evasion directly rather taking a risk.

A tax distortion: is a provision of the tax code that can influence a taxpayer’s behavior, over and above the fact of taxation itself. The tax paid is not a loss to society, since it is merely transferred from taxpayer to government. E.g tax on cigarettes and beer.

Compliance costs: the costs to taxpayers and others of paying taxes, over and above the tax itself (that is, the cost of learning about the tax, keeping records, preparing tax returns, dealing with tax auditors, resolving misunderstandings with the tax authorities, etc.)

Single Business Permit: is “a permit that allows the conduct of a business or trade, including a profession or occupation, within the area of a local authority.” (Legal Notice No. 5313 of 1999)

Tax morale: the intrinsic motivation to pay taxes arising from the moral obligation to pay taxes or the belief in contributing to society by paying taxes

Tax non-compliance
Based on the definition, “noncompliance can occur through failure to file a return,
Misreporting income, or misreporting allowable subtractions from taxable income or taxes due (i.e., exemptions, deductions, adjustments, and tax credits)” [ibid. page 2].
(Flynn, 2003)

Tax administration practices: the interactions between taxpayers and tax authorities concerning identification of tax liabilities, actual tax payment and collection, and prosecution and penalty of tax evaders (Das-Gupta & Mookherjee, 1998: 28). They are transaction intensive, often involving face to face contacts between taxpayers and tax officers.
CHAPTER ONE

INTRODUCTION

1. Background to the Study
The existence of a tax system forces individuals to give part of their income to the government as tax payments. Since individuals dislike paying taxes, different strategies geared towards reducing the tax burden emerge associated to the strategic behavior of taxpayers. There are different ways to reduce the fiscal burden of an individual relative to that of other taxpayers with the same economic characteristics. Tax evasion is most common alternative that has been analyzed in the tax compliance literature (Panadés, 2002).

A large body of the economic analysis on the tax evasion phenomenon has been based on the formalization proposed by Allingham and Sandmo (1972). According to this approach, individuals voluntarily decide which part of their income they will declare, taking into account both the saving associated with paying only the taxes associated with declared income and the potential cost appearing if this illegal behavior is discovered and thus punished. The existence of fraudulent behavior, whether punishable or not, has important effects on the performance of an economy and is therefore a major concern for all governments including at the local level.

The tax gap therefore arises when taxpayers fail to comply with the tax laws, either intentionally or unintentionally. Non-tax compliance is a matter of serious concern in many developing countries, limiting the capacity of their governments to raise revenues for developmental purposes (Burgess and Stern, 1992; Das-Gupta, Ghosh and Mookherjee, 2004). As a result of tax noncompliance, the burden of funding the nation’s commitments, including funding growing budget deficits, falls more heavily on taxpayers who voluntarily pay their taxes. Thus one of the more vexing problems for policy makers in developing economies is encouraging high levels of tax compliance. High tax compliance is necessary for efficiency and equity as well as for the development of social capital (Slemrod, 1998). As Cowell (1990) notes, “… the issue of evasion is, unlike other illegal activities, inseparably bound up with the instruments of fiscal control that the government attempts to use in carrying out its economic policy.” While reducing evasion improves the government’s revenue, it is a broader issue for the development of a civil order (Knack and Keefer, 1997). Reducing tax evasion is not simply a matter of applying higher penalties and/or increasing the frequency of audits. Extreme penalties may backfire by creating a setting in which bribery, and corruption is more prevalent and the end result may be lower tax compliance and a general loss of trust in the public institutions.

As a complex phenomenon, tax compliance can be addressed from a variety of perspectives. Taxpayers’ stance is influenced by many factors, including their disposition towards public institutions, the perceived fairness of the taxes, prevailing social norms, and the chances of noncompliance being detected and punished. Designing effective policies for reducing tax evasion requires understanding the behavioral, demographic and economic and institutional aspects of the tax compliance decision. If we find that individual attitudes toward compliance are a function of social and cultural norms, demographic and economic factors, enhancing these is a desirable policy instrument to complement the usual enforcement options.

Among highly competitive, small-scale and (typically) labor-intensive businesses, proprietors will often resort to strict cost-controls and be prepared to operate at low profit margins. However, this can be achieved in both formal and informal ways. Many “… (especially recent start-ups) may revert to informal practices by cutting corners with respect to taxes, labor regulations, minimum wages, and also, possibly, by engaging in other, illicit, transactions (Kloosterman and Rath, 2001). Conversely, tax compliance is enhanced when individuals view the paying of taxes as a fair fiscal exchange. In such situations compliance is likely to increase, ceteris paribus. In particular, when the services provided by the government are viewed as widely desired and the decisions determining the services provided are transparent and fair, compliance is likely to be higher (Cummings et. al, 2006)

In purely economic models, the decision whether to evade at all turns out to depend only on this comparison: if the expected gain is greater than the expected loss, the taxpayer decides to evade at least a little. How much is evaded depends on the aversion to risk, the expected gain, and the risk faced by the taxpayer. This approach highlights a number of factor’s that determine whether and to what extent taxes are evaded. These are: the magnitude of potential savings (which, on the margin, is simply equal to the tax rate), the probability of getting caught, and penalties when caught. More subtly, the extent (but not the presence) of evasion depends on risk aversion, which itself may be a function of the level of income, and it may depend on the tax liability. The ideal compliance policy should target both tax avoidance and tax evasion; both of which involve a loss of revenue and both involve a loss of economic welfare. The loss of revenue implies an additional economic cost because the revenue must be recouped by resorting to further distortionary taxation. For decades, tax researchers have investigated why some people pay taxes while others do not. Through experiments (Boylan and Sprinkle 2001), random surveys (Fisher et al., 1989), and available tax databases (Erard and Ho 2001), researchers have identified characteristics of noncompliant taxpayers and what is likely to motivate tax compliance. Factors related to tax administration efficiency and institutional capacity have however been ignored in academic literature.

Licensing of businesses by LAs is a common practice in Kenya. Its objective is brought into focus as a result of a global trend towards decentralization, which places expectations on local governments to generate additional resources in order to finance the delivery of quality services and development under the Kenya Local Authorities Reform programme initiative (World Bank, 1997; Ters-Minassain, 1997). Among other licenses levied by Nairobi City Council is the SBP that in 1999 replaced the opaque multiple trade licensing system. The introduction of the SBPs by the Ministry for Local Government in LAs was underpinned by the realization that the former business licensing system had high compliance costs to businesses due to multiplicity and complexity of the procedures, illogical tariff structures, inefficient regulatory requirements which provided opportunities for rent-seeking, poor administration and evasion which reduced the tax base and generated inequalities and also a revenue source which generated relatively little income for the Local Authorities, with little scope to increase the yield (Devas and Kelly, 2001). A business is therefore required to have one business permit per business, regardless of the activities carried out. The issuance of the permit is based on a standard tariff structure that uses a generic classification of businesses onto eight sectors, sub-divided into broad categories reflecting the scale or nature of the business. The size and number of employee’s categories are based on easily identifiable and objective criteria.

As a result of its implementation, most LAs reported substantial increases in revenue. When all LAs introduced the SBP, revenues from this source increased by 33% (see Table 1.1). For some, the revenues increased dramatically- 20 LAs more than doubled their revenue from this source in one year. With regards to compliance costs, a study by Abuodha and Bowels (2000) suggested that the time taken to obtain the permits had significantly reduced thus effectively reducing the compliance costs. It is based on the principles of a one stop shop.

Table 1.1: Revenue from SBP
|Millions of Kenya Shs. |1980-99 |1999-2000 |Increases |
|159 LAs with data from both years |743.1 |986.8 |32.8% |
|36 LAs implementing SBPs in 1999 |139.4 |176.9 |26.9% |
|123 LAs implementing SBPs in 2000 |602.4 |807.5 |34.0% |

Source: Devas and Kelly (2001)

2. Statement of the problem
It was recognized at the policy level that if LAs were to be strengthened to become effective vehicles for local service delivery and development, they needed to have adequate revenues. This was especially so before the introduction of LATF when the LAs were in serious financial constraints. Early evidence from the reform of local business licensing in Kenya which introduced the SBP indicates that it enabled LAs to collect significantly more revenue while at the same time reducing compliance costs on businesses and the opportunities for rent seeking.
However, as years progressed, the revenue sources have become less buoyant against a backdrop of buoyant growth in the economy. Data from the Nairobi City Council estimates that there are currently 91,321 businesses eligible for SPB within its area of jurisdiction and yet only 59,863 are reportedly complying. This represents a compliance rate of about 65%. In all Tax compliance areas, the level of noncompliance has remained high despite all the efforts put in by the tax administration (kiriga 2005). A study also done by Bwire 2007, tried to explain factors influencing collection of taxes to achieve the desired targets.

The erosion of the SBP tax base has several detrimental fiscal effects. The consequences of lost revenue to the funding of public services are of special concern. This has implications on the Council’s revenue mobilization efforts, closing on the resource gap, the tax payers’ and residents’ economic and social welfare. When businesses do not pay their tax due, honest taxpayers carry a greater burden to fund local government programs and the City Council is less able to address its long-term fiscal challenges. These challenges lend to the question on the factors that affect SBP compliance by SMEs.

3. Objectives of the Study
Broad Objective
The general objective of this study is to determine the factors affecting compliance of the Single Business Permit Tax by Small and Medium Enterprises in Nairobi’s Kasarani Constituency.

The specific objectives include: 1. To establish whether the SBP tax administration procedures affect the level of compliance of SBP by SMEs. 2. To establish whether the provision of tax incentives affect the level of compliance of SBP by SMEs. 3. To find out whether computerization affects the level of compliance of SBP by SMEs. 4. To determine whether education and training of SME owners affect the level of compliance of SBP by SMEs. 5. To establish if procedures affect the level of compliance of SBP by SMEs

1.4 Research Questions

This study will attempt to answer the following research questions:

1. What are the effects of SBP tax administration procedures on the level of compliance of SBP by SMEs? 2. Does the provision of tax incentives affect the level of compliance of SBP by SMEs? 3. How does computerization affect the level of compliance of SBP by SMEs? 4. Does education and training of SMEs owners affect the level of compliance of SBP by SMEs?

1.5 Significance of the study

Measuring compliance and its related factors offer many benefits, including helping NCC identify new or growing types of noncompliance, identify changes in tax laws and regulations that may improve compliance, more effectively target examinations of SBP tax returns, understand the effectiveness of its programs to promote and enforce compliance, and determine its resource needs and allocations. This will be insightful to the policy makers at the City Hall on the priority areas to address in order to curb tax evasion and tax cheating and thus maximize on the compliance function. The outcome of this tax compliance research data will be useful outside of NCC as well. Other LAs can use compliance data for tax policy analysis, revenue estimation, and research. Stakeholders can also use the outcome of the study to ensure transparency of revenue collection and also demand better service delivery. To the government especially the Ministry of Local Government, the results of the study will form policy direction on SBP administration going forward especially on the premise of Local Authorities Reform programme.

1.6 Scope of the study

The study will be conducted in Kasarani constituency, a jurisdiction under Nairobi City Council in the Republic of Kenya. The study will be limited to measuring compliance of Small and Medium Enterprises and the factors that affect the same for the single Business permit. The questionnaires will be administered to the businesses eligible for the SBP, with particular reference to the business owners / representatives.

CHAPTER TWO LITERATURE REVIEW

1. Introduction

This chapter intends to look into the literature review of the research study being undertaken and includes past studies done in the area of compliance of SBP tax in LAs and issues that arise in compliance of SBP. The researcher will also formulate a conceptual frame work.

2. Concept of Tax Compliance
Tax compliance is when taxpayers are willingly meeting their obligations in accordance to the Taxation laws and regulations. James and Alley (1999) define tax compliance as the willingness of individuals and other taxable entities to act in accordance within the spirit as well as the letter of tax law and administration without the application of enforcement activity.

Franzoli (1999) states that compliance with the tax law typically means: true reporting of the tax base, correct computation of the tax liability, timely filing of the return, and timely payment of the amounts due. The bulk of tax evasion involves the first point as most evaders either do not declare their liability at all, or declare it only in part.

It is commonly acknowledged that many factors contribute to this problem and include; corruption, a large informal sector, weak legal systems, ambiguity in tax laws, high marginal tax rates, paucity of adequate information and accounting systems, a culture of noncompliance, and ineffective tax administration (Burgess and Stern, 1992; Das-Gupta, Ghosh and Mookherjee, 2004).

2.3 Tax Procedures
Tax structures can either facilitate or frustrate tax compliance (World Bank, 2006). College and Easter (2003) suggest that tax noncompliance is significantly influenced by uncertainty and complexity of the tax law. Complexity of tax regulations raises compliance costs and fosters non-compliance.
According to Franzoni (1999), high compliance costs, which may be due to complex tax schedules and rules, not only tilt the ‘cost-benefit analysis’ towards evasion, but may also generate resentment, weakening taxpayers’ moral conscience or even prompting them to evade as a form of ‘punishment’ for the tax administration. Again, when the tax legislation is very complex, taxpayers usually have to turn to tax experts, who have great power to influence their clients’ attitudes towards evasion, owing to their superior knowledge of enforcement patterns. An interesting empirical study by Franzoni (1999 ) on the United States suggests that tax preparers encourage compliance with regard to unequivocal items, and discourage it with regard to ambiguous ones. On the other hand, Taxes based on clear laws and not requiring contacts between taxpayers and tax inspectors are less likely to lead to acts of corruption.

Tanzi (1998) writes that corruption is likely to be a major problem in tax administration, when laws are difficult to understand and can be interpreted differently so that taxpayers need assistance in complying with them. In addition, when the administrative procedures (for example the criteria for the selection of taxpayer audits) lack transparency and are not closely monitored within the tax administrations the potential for corruption is likely to increase. Most importantly, public sector corruption will be pervasive when acts of fraud on the part of the tax administrators are ignored, not easily discovered, or when discovered – penalized only mildly. In a series of papers, Tanzi and Davoodi (1997) have provided evidence that countries with high levels of corruption tend to have lower collection of tax revenues in relation to GDP. The implication is that some of the taxes paid by taxpayers are diverted (to tax administrators). Simplifying tax and tariff schedules, and keeping rates at moderate levels, thereby reduces the discretion of tax (and customs) staff and narrows the scope for corrupt payments.

Research focusing on perceptions of complexity indicates that complexity is associated with compliance, but the impact remains unclear. Clotfelter (1983) found that the complexity of the return was associated with noncompliance. However, Westat (1980), Witte and Woodbury (1985) and Slemrod (1989) find that the impact of complexity on compliance varies with individual taxpayer characteristics such as perceptions of fairness, opportunity to evade and education. Tax complexity increases the likelihood that taxpayers are non-compliant unintentionally. This has an important policy consequence: when taxpayers make honest mistakes, enforcing taxes is harder because it requires distinguishing between cheaters and honest-but-confused taxpayers. Therefore, complexity reduces the effectiveness of standard enforcement tools such as detection or penalties.

Kopczuk (2006) argues that while the implications of tax complexity are multi-dimensional, its most important consequence is the extent of opportunities for tax avoidance and evasion that it creates. Tax complexity increases the likelihood that taxpayers are non-compliant unintentionally. This has an important policy consequence: when taxpayers make honest mistakes, enforcing taxes is harder because it requires distinguishing between cheaters and honest-but-confused taxpayers. Therefore, complexity reduces the effectiveness of standard enforcement tools such as detection or penalties.

Efforts to simplify the tax code may help reduce the tax gap by making it easier for individuals and businesses to understand and voluntarily comply with their tax obligations. Among the many causes of tax code complexity is the growing number of preferential provisions in the tax code, such as exemptions and exclusions from taxation, deductions, credits, deferral of tax liability, and preferential tax rates (GAO, 2005).

2.4 Tax Incentives and Tax Sanctions
Apart from incentives such as quality provision of goods and services to motivate people to pay tax, incentives such as awards for tax compliance to be given to those who have fulfilled their tax obligations has proved effective in enhancing tax compliance in a number of countries (Ayee, 2007). Also Tax amnesty as was given by the Minister for Finance in the 2004/2005 budget to cover penalties, fines and interests on undeclared or unremitted taxes. Tax amnesty allows businesses and individuals to pay their tax debts while helping the government raise revenues without generating new taxes (GoK Finance bill 2004). Giving taxpayers incentives therefore may have a positive effect on compliance behavior by enhancing compliance. Tax incentives go hand in hand with tax penalties for noncompliance.

With respect to penalties, it has been well known since Becker (1968) that a government concerned with maximizing the expected utility of a representative citizen will want to set the penalty for detected crimes as high as possible, so that even with a low resource cost of enforcement, the overall expected deterrent effect will be large. But this argument ignores, inter alia, the possibility of a corrupt tax administrator who abuses the system or, alternatively, harshly punishes someone who makes an honest mistake. The harsher the penalty, the more damage that can be inflicted by a corrupt administrator or, in the case of an honest mistake, the more capricious the system is. Hence the harsher the penalty, the more detailed and cautious the prosecution process must be. In addition, with harsher penalties courts may be more reluctant to find the taxpayer guilty of evasion, so that one consequence may be fewer penalties imposed.

According to the WB (2006), penalties should however be reasonable as unreasonably high penalties are typically unenforceable, not applied, not collected, and some instances, induce negotiation with attendant corruption and rent seeking. Payment of interest on late payment of taxes should also never be forgiven to enhance compliance.

It is widely accepted that the goal of an efficient tax administration is to foster voluntary tax compliance using all possible methods including penalties. Penalizing tax evaders or going after delinquent taxpayers are not in themselves the object of tax administration, although it would serve to encourage voluntary compliance if the taxpayers believe that the tax administration can effectively detect and punish noncompliance

Cost-effective field audits are a critical tool in achieving compliance under a self-assessed tax system (WB, 2006). The major scope for more cost effective audits should target less than 10% of tax payers per year while more superficial inspections can be done with greater frequency to foster tax compliance.

2.5 Computerization of Tax Administration
Leveraging technology improves tax authority capacity to receive, process, and utilize taxpayer returns enhance tax compliance (GA0, 2006). Modernized technology facilitates electronic tax filing which ensures fast and more accurate processing and quicker interactions between the tax authority and the taxpayers. This improves tax administration efficiency and substantially reduces physical contact between taxpayers and employees of the tax authority and thus limits rent seeking and corruption.
Friedman (2003) states that people are willing to pay tax depending on the technical efficiency of the revenue authority that includes not only on its administrative and accounting techniques but also its level of IT sophistication.

World Bank (2006) posits that the internet offers enormous scope for e-government including timely, accurate and cost-effective e-publishing of tax documents, e-filing of tax returns and e-payment of tax liabilities. The use of internet-based communications with the tax-paying populations therefore represents a major opportunity for implementing more cost effective tax administration and raising tax efficiency levels, though in many countries limitations in the internal computer systems will limit the ability to effectively use e-filing and e-payments information

According to World Bank analysis (WB, 2004) computerization of tax administration is an important element of capacity building and revenue administration. The most obvious benefit of computerization is more effective revenue collection due to better audit selection, easier detection of non-filers, and faster payment and refund processing. Information technology can also increase the transparency of tax and customs administration, and thereby reduce corruption.

Information reporting is a central element of modern tax systems’ implementation because it can provide the tax authority with transaction-based information from an arms-length party with no incentive to falsify the data. Thus, a working system of information reporting discourages noncompliance by increasing the risk of detection (Joel Slemrod, Whiting and Shaw, 2006).
According to (Bird, 2004), the priority area that foster tax compliance are systems related to taxpayer records and tax collection and should ideally have such basic modules on taxpayers or taxpaying units, such as a taxpayer master file or registration system.

The computerization of the tax administration systems allow for on-line filing of tax forms can potentially eliminate many opportunities for corruption. Further, computerizing the tax system would enhance the adequacy of administrative procedures including: compliance, tax audit, taxpayer services, sanctions and appeals, customs clearance procedures, pre-shipment inspection, and information sharing.

6. Tax Education and Training
Learning is the process by which a person acquires new knowledge, skills and capabilities. Training is the use of a systematic and planned instruction and development activities to promote learning (Armstrong, 2005). Training of staff will increase their knowledge of understanding the laws and policies, rules and procedures governing SBP. It also increases good customer care and helps in educating and enlightening the tax payers.

Providing quality services to taxpayers is an important part of any overall strategy to improve compliance and thereby reduce the tax gap. One method of improving compliance through service is to educate taxpayers about confusing or commonly misunderstood tax requirements (GAO, 2003). For instance, if the forms and instructions taxpayers use to prepare their taxes are not clear, taxpayers may be confused and make unintentional errors. One method to ensure that forms and instructions are sufficiently clear is to test them before use.

Sarker (2003) posits that tax education and counseling encourage the voluntary submission of accurate tax returns and payment of taxes which fosters compliance. The inculcation of a culture of tax compliance depends on changing attitudes and perceptions. Therefore, a more concerted and sustained approach to Tax Education aimed at sensitization of the public fosters their level of compliance (Ayee, 2007).

IIRS (1994) has stated that unintentional noncompliance likely represents a significant amount of total noncompliance. Survey respondents indicated that tax payers fail to pay their tax because they were not aware that any tax was owed.

7. Empirical Literature on Tax Compliance
Semboja (2001) paper examines factors determining tax compliance behavior in local authorities in Tanzania. The study finds support for the hypotheses that tax compliance is positively related to factors such as ability to pay, the (perceived) probability of being prosecuted and the number of tax evaders known personally by the respondent. Oppressive tax enforcement, harassment of taxpayers and discontent with public service delivery seem to increase tax resistance and may explain the widespread tax evasion observed.

A plethora of other empirical literature on tax compliance have mainly focused on taxpayers’ attitudes surveys. Though much work has been done in this area, and results cannot be easily generalized (see, among others, Kinsey, 1992; Sheffrin and Triest, 1992; and de Juan, Lasheras and Mayo, 1994). On the whole, the following factors have been found to be significant determinants of tax compliance: the perceived probability of detection; the severity of sanctions; moral beliefs about tax compliance; experience with other noncompliers and past experience with tax authority enforcement and demographic characteristics (older people seem to be more compliant) (Klepper and Nagin, 1989). These survey studies face several problems, however. First, results depend crucially on the representativeness of the sample, which is often difficult to assess. Second, respondents are reluctant to report acts of noncompliance (see, for instance, Elffers, Weigel and Hessing, 1987). Third, causal relationships are difficult to establish. Finally, individuals often seek to provide a consistent image of themselves, offering ad hoc rationalizations for their behavior (Elffers, Weigel and Hessing, 1987).

Another increasingly widespread empirical approach is based on ‘laboratory’ experiments (see, for instance, Webley et al., 1991; Alm, Cronshaw and McKee, 1993; Alm, Jackson, and McKee, 1993; and Alm, Sanchez and de Juan, 1995). Individuals (often students) are asked to participate in games simulating tax compliance, where they can underreport and incur the risk of a penalty. At the end, they receive a real reward proportional to their laboratory performance. The results tend to be very sensitive to the particular design of the experiment. In general, this research suggest that audit rates may play an important role in compliance decisions (especially for those who have already been audited), and that compliance is an increasing function of income and a decreasing function of the tax rate, while it is hardly affected by the size of fines (unless the audit rate is very high). These experiments also suggest that social norms and ethical attitudes play an important part in evasion choices, that individuals often take an all-or-nothing stance, that they tend to overweight low probabilities, and that the structure of the taxes is important (Baldry, 1987).

While the empirical research is far from conclusive, it does appear to support the hypothesis that expected punishment (that is, the size of sanctions discounted by the probability of incurring them) is relevant. Sociological and ethical factors surely play an important role too, although their effect is subtler and harder to measure. This suggests that standard enforcement polices based on apprehension and punishment should not be abandoned. They could be supplemented by alternative approaches, seeking to appeal to taxpayers’ moral conscience or to reinforce social cohesion. Our focus however is to explore these alternative approaches viz: incentives, tax education, leveraging on IT, and simple tax procedures.

8. Summary and Gaps to be Filled by the Study
From the foregoing, there is no doubt that compliance is a major problem confronting all revenue authorities. However, it is a complex subject with broad implications. There are two main approaches in the literature on tax compliance: the economic and the behavioral, which have been used to encourage taxpayers to comply with the taxation system. The economic approach, usually confined to penalties, may be necessary to enforce compliance by those taxpayers who would otherwise refuse to discharge their obligations as citizens. However, there are dangers in using such an approach more widely.

It is suggested that taxation is a means to an end and an unnecessarily harsh enforcement regime, such as that which appears to have been used in some countries, detracts from the whole exercise of raising money for the public benefit. Furthermore, such harshness can reduce the willingness of otherwise responsible citizens to comply with what may then be perceived as an unjust system. Empirical Work on socio- demographic factors such as attitudes, beliefs and others on compliance finds, in general, that individuals who place greater trust in government, believe that the tax system is fair and equitable, and believe that others generally comply with tax laws are more compliant. Women and older individuals are found to be more compliant than others.

These two approaches emphasize the clear need to strike the right balance in encouraging voluntary compliance and deterring willful non-compliance but fail to address the need to improve revenue authorities’ institutional revenue administration efficiency and capacity to maximize tax compliance. Compliance, however, in addition to focusing on the two approaches, is most likely to be optimized when a revenue authority pursues a citizen-inclusive approach to compliance through policies that encourage dialogue and persuasion, combined with an effective mix of incentives, simple and less burdensome tax procedures, tax education and leveraging on IT. There has, to date, been relatively little research that has used this line of thought to study tax compliance. The literature gap that the current research seeks to fill is to rate in order of relative weights, how complex tax procedures, tax incentives, computerization, and tax education affect SMEs’ compliance to the SBP in Kenya.

9. Conceptual Framework

The researcher conceptualizes that complex tax procedures, tax incentives and sanctions, computerization, and tax education and training (independent variables) affect SMEs level of tax compliance (dependent variable) as illustrated in Figure 2.1.

Figure 2.1: The Schematic Diagram Showing Variable Relationships.

Affecting

Independent variables Dependent variable Source: MWANGI J. G 2008

CHAPTER THREE

RESEARCH METHODOLOGY

3.1 Introduction
This chapter will outline the general methodology to be used to conduct the study. It is organized into the research design, target population, sample frame and sampling techniques, data collection and data analysis.

3.2 Research design
The design to be used will be the survey method incorporating both quantitative and qualitative methods. The quantitative method will be favored as it provides testable and empirical data, Mugenda and Mugenda (1999); Donald and Pamela (2003).

3.3 Target population
The research is expected to cover all SBP eligible businesses in Kasarani constituency. Information from the NCC SBP business register estimates them to be 8000.

Borg and Gall (1989) define target population or the universe of study of all the members of a real or hypothetical set people, events or objects to which an investigator wishes to generalize the results of a research study. Again Mugenda and Mugenda (2003:41) defines the population as a complete set of individuals, cases or objects with some common observable characteristics. The population characteristics are summarized in Table 3.3:

Table 3.3 Target Population Sub sector Population Percentage % 1. Retailing Business 4000 50.0 2. Production (engineering) 1000 12.50 3. Agricultural 500 6.25 4. Transport 300 3.75 5. Light Industries 200 2.50 6. Informal businesses 2000 25.0 Total 8000 100

3.4 The Sample and Sampling technique:
Stratified sampling technique will be adopted in coming up with a representative sample. The sectors under which the business fall will form independent strata which will then be sampled and all businesses falling within the sampled strata studied. The researcher expects to draw a 10% representative sample size (80 traders). This is in concurrence with Donald and Pamela (2003) which posits that a sample of 10% of the total population is adequate for stratified random sampling in circumstances of infinite population sizes. Mugenda and Mugenda (1999) conceptualizes that stratified sampling is appropriate where it is possible to classify members of a population that are homogeneous within themselves and heterogeneous without themselves. This sampling procedure ensures that each sector achieves representation in the sample. The design is represented in Table 3.2.

Table 3.4 Sample Design
|Sub sector |Population |Sample |Sample size |
| |Frequency |(businesses) |Respondents |
|Retailing |4000 |400 |40 |
|Production |1000 |100 |10 |
|Agriculture |500 |50 |5 |
|Transport |300 |30 |3 |
|Industries |200 |20 |2 |
|Informal |2000 |200 |20 |
|Total |8000 |800 |80 |

3.5 Data collection
The study will use mainly primary data from traders forming the sample. This method is appropriate as it is most authoritative because the information has not been filtered by a second party (Cooper et. al, 2003). The researcher will use a validated semi-structured questionnaire for data collection. The questions will both be closed and open-ended and will be structured in both yes/ no basis and on a five-point likert scale. Sections will include: demographics, SBP tax compliance, Tax procedures, tax education, tax incentives, and computerization.

6. Research Procedures
A pilot survey of 10 respondents will be conducted in pre-testing the questionnaires for validity and practicality. The lessons for the survey shall form a basis for the review of the questionnaire administration for the main survey. The final survey will be self administered. Drop and pick latter approach will be utilized. Response rates will continuously and closely be monitored by making follow up reminder calls to the respondents after the survey is distributed. To ensure quality of responses the respondents will be urged to be as honest as possible in filling the questionnaire. Again, participation will be voluntary, anonymous and confidential. A cover letter signed by the researcher explaining the purpose of survey and the value to the participants, how the survey information will be used, how to complete the survey and assurance of confidentiality and anonymity will also be attached.

3.7 Data analysis
After all the questionnaires are returned, the researcher will scan and correct the data for errors and omissions. The data will then be coded and entered into an SPSS database and thereon analyzed using regression methods to test the model and identify the factors that affect compliance. The presentation will be reflected in ANOVA table to depict the relationships and trends between the dependent and independent variables.

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APPENDIX I: RESEARCH WORK PLAN

| |CALENDAR YEAR 2008 | |
|Activity |Early Feb |Mid March |Early April|Mid June |Early July |Mid Aug |Early Sept |
|Topic selection | |
|Production |[ ] |
|Agriculture |[ ] |
|Transport |[ ] |
|Industries |[ ] |
|Informal |[ ] |

1. SBP category code…………………………. 2. Number of years since the business was established Less than 1 year [ ] 1-2 years [ ] 2-3 years [ ] More than 3 years [ ] 3. Ownership Structure Sole trader [ ] Partnership [ ] Ltd Company [ ] 4. Number of employees…………………………. 5. Total capital investment outlay in Kshs……………… 6. Business/ market focus: International [ ] locally based [ ]

C. COMPLIANCE 7. Are you aware of your SBP tax obligations/ tax due in the financial year 2006/07? Yes [ ] No [ ] 8. The amount of SBP paid in 2007………………………………………. 9. In your opinion, do you think the SBP tax liability amount that was due in 2007 was correctly computed? Yes [ ] No [ ] 10. Is your SBP category schedule going to change this year? Yes [ ] No [ ] 11. Are you comfortable in paying a higher amount? Yes [ ] No [ ] 12. Do you pay SBP before the due date? Yes [ ] No [ ] 13. Do you file your SBP before the due return date? Yes [ ] No [ ] 14. How do you find the SBP rate? Minimal [ ] Manageable [ ] Too large [ ] Threat to business [ ]

D. FACTORS AFFECTING TAX COMPLIANCE

Tax Procedures 15. Please estimate the time you require to complete requirements for paying the SBP.................... 16. Do find you consider the SBP tax schedules and rules certain and less complex and simple to comply with? Yes [ ] No [ ] 17. Do you incur any other indirect costs in order to comply with the SBP tax requirements? Yes [ ] No [ ]

If yes please specify the amount and explain……………………………..

18. The SBP tax liability returns are prepared by: (tick one) Self [ ] accountant employee [ ] hired tax expert [ ] 19. Would you say that SBP tax legislation is complex? Yes [ ] No [ ]

If yes, explain………………………………………………………………………

Incentives: 20. Would the possibility of being penalized financially motivate you to pay your SBP in time and accurately? Yes [ ] No [ ] 21. Would you want those who are non-compliant to the SBP to be punished? Yes [ ] No [ ] 22. Would you want those who are non-compliant to the SBP to be punished? Yes [ ] No [ ] 23. If the NCC was to offer you tax incentives like reducing the SBP tax rate, taxpayer awards, would you be more willing to pay the SBP in time and accurately? Yes [ ] No [ ] 24. In your opinion, do you think the NCC is doing enough to improve the quality provision of goods and services and the welfare of residents and the business community with the revenue it collects? Yes [ ] No [ ] 25. In your opinion, do you think the NCC is doing enough to improve the quality provision of goods and services and the welfare of residents and the business community with the revenue it collects? Yes [ ] No [ ]

Computerization of Tax Administration 26. How would you rate the current paper based approach for SBP administration by the NCC? Excellent [ ] Very good [ ] Good [ ] Poor [ ] Very poor [ ] 27. If NCC was to modernize its SBP tax administration through e-filing of tax returns, provision of downloadable forms on its website, and e-payment of tax liabilities and electronic refund processing, would you be more willing to correctly compute, timely file and timely pay your tax liability. Yes [ ] No [ ]

Tax Education 28. Have you ever attended NCC SBP tax education programs? Yes [ ] No [ ]

29. Do the SBP tax officers clearly explain the SBP forms and instructions? Yes [ ] No [ ]

30. In your opinion, if NCC was to regularly hold tax payer education programs on the SBP, would you be more willing to comply to the tax requirements? Yes [ ] No [ ]

E. RECOMMENDATIONS 31. What recommendations would you give to the NCC and the Ministry of Local Government in order to enhance SBP compliance levels?

Nairobi City Council ……………….…………………………………………………………………………….………………………………………………………………………………… Ministry of Local Government ………………………………………………………………………………………………………………………………………………………………………………

Appendix iv: Single Business Permit Fee Schedule (Kenya, 1999) [pic]

[pic]

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Tax education & training

Computerization

Compliance with SBP

Tax incentives and sanctions

Tax procedures

References: Appendix iii:Questionnaire………………………………………………………………26 Appendix iv:Single Business Permit (Kenya Gazette 1999)………………………….....32