INFORMAL SECTOR TAXATION AND REVENUE MOBILIZATION IN DEVELOPING ECONOMIES
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Abstract
About This Research Topic
The informal sector dominates employment and output across Sub-Saharan Africa, accounting for 40-60% of GDP in countries like Nigeria, yet contributes disproportionately little tax revenue. This revenue paradox makes informal taxation central to domestic resource mobilization. Kano metropolis, anchored by historic markets like Kurmi and Kantin Kwari, exemplifies both the scale and complexity of the challenge. While early policy treated the informal sector as an untapped base for presumptive taxes, recent scholarship emphasizes governance gains, equity, and tax morale spillovers. See our economics research project topics This article rewrites the original project on informal sector taxation in developing economies, preserving its Tobit methodology and Kano evidence while adding analytical depth and SEO structure for Scholarnesthub readers.
Main Abstract
This study examines determinants of informal-sector tax and levy payment and estimates revenue-mobilization potential in Kano metropolis using a Type I Tobit censored regression. The informal sector is large in Sub-Saharan Africa but contributes little tax, with many operators paying zero—a feature OLS handles poorly. Grounded in Allingham and Sandmo’s economic deterrence model, Ability-to-Pay Theory, and tax morale/institutional theory, the study surveyed 350 traders, artisans, and service providers in Kano, where 37.7% reported paying no formal tax or levy in the prior twelve months. Tobit results show business income (β=3,534.13, p<0.001), business size, and years operating significantly affect payment as ability-to-pay factors; tax morale (β=2,431.97, p<0.001), perceived enforcement (β=2,249.19, p<0.001), and trust in government (β=1,461.91, p<0.001) are independently significant; trade association membership is the strongest binary determinant (β=5,147.96, p<0.001). McDonald and Moffitt marginal effects decomposition confirms association membership, income, and size as largest unconditional contributors to expected revenue. Observed average payment was ₦4,379.60 versus model-implied average if all paid according to latent capacity-willingness of ₦6,403.13, implying 31.6% revenue potential from closing compliance gaps rather than sector growth. The study recommends community-taxation partnerships with market associations combined with trust-building and credible enforcement communication as most promising levers for Kano State and comparable jurisdictions
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Background to the Study
Nigeria’s informal economy is vast, fragmented, and largely cash-based. National accounts understate its scale while fiscal planning treats it as marginal. Kano State’s commercial hubs host tens of thousands of micro-enterprises where state presence is mediated by market associations rather than direct tax administration. Literature has evolved from revenue-first presumptive taxation to recognizing five motives for taxing informality: fiscal magnitude, growth via formalization, governance and accountability, equity versus formal firms, and boosting formal sector morale. Yet recent panel evidence finds the informal sector reduces domestic revenue mobilization overall, and higher compliance burdens can dampen growth, indicating a trade-off. World Bank on informality and domestic revenue mobilization highlights similar challenges globally. IMF work on revenue mobilization in developing economies underscores that enforcement alone rarely closes gaps without legitimacy. This study contributes micro-econometric evidence using a Tobit model suited to zero-heavy payment data, bridging perception surveys and macro panels. For methodological parallels, see taxation research project guides
Statement of the Problem
Policymakers face a tension: scale makes informality attractive to tax, but compliance remains low and drivers of why some pay while many pay zero remain poorly modeled. Nigerian studies have examined awareness and perception in Oyo North and cross-country panel effects on revenue, but no identified study applies Tobit censored regression to individual-operator data in a major Northern hub like Kano, despite Tobit’s appropriateness for zero-censored outcomes. Without separating the extensive margin (whether to pay) from intensive margin (how much to pay), policy conflates distinct levers. This study addresses that methodological and geographic gap using primary survey data from Kano.
Aim and Objectives
Aim: Examine determinants of informal-sector tax/levy payment in Kano metropolis and estimate revenue-mobilization potential using Tobit framework.
Objectives:
1. Determine incidence and average level of tax/levy payment.
2. Estimate determinants using Tobit accounting for substantial zero share.
3. Decompose effects into probability of paying and amount conditional on paying (McDonald-Moffitt).
4. Estimate revenue potential from closing compliance gap.
5. Draw policy conclusions for Kano and similar jurisdictions.
Research Questions
1. What proportion pays zero and what is average payment among payers?
2. What operator/business characteristics determine payment accounting for censoring?
3. Do tax morale, perceived enforcement, and trust affect payment independent of ability to pay?
4. What is revenue potential if compliance gap were closed?
Research Hypotheses
H0₁: Business income has no significant effect on payment.
H0₂: Tax morale, enforcement, and trust have no significant independent effect.
H0₃: Trade association membership has no significant effect. Tested at 5%.
Significance of the Study
For Kano State Internal Revenue Service and similar sub-national agencies, findings identify which levers—income, morale, enforcement, trust, association—most strongly associate with payment, informing strategy. For Joint Tax Board and FIRS, it provides micro evidence complementing national panels. For market associations, it validates community-taxation models. Academically, it adds Tobit-based micro-econometrics to a literature dominated by descriptives or macro GMM. Related discussions on informal economy and taxation project topics
Scope of the Study
Delimited to informal operators—traders, artisans, service providers—in Kano metropolis. Examines formal tax/levy payments (state/local levies, receipted market dues, presumptive taxes) in prior 12 months in relation to business, operator, and attitudinal characteristics.
Limitations
Self-reported income and tax data subject to under-reporting due to sensitivity; confidentiality emphasized. Cross-sectional design cannot track dynamics. Revenue potential estimate is model-based extrapolation from Tobit, not audit-based forecast. Geographic concentration in Kano may not generalize to Lagos’s fragmented informal retail economy.
Operational Definition of Terms
Informal Sector: Unregulated or semi-regulated trading, artisanal and service enterprises not fully captured in official accounts.
Tax/Levy Payment: Formal tax, market due, or presumptive levy paid to government or authorized agent in prior 12 months, in Naira.
Censored Data: Outcome known exactly for some observations but only known to be at/below threshold (zero) for others.
Tobit Model (Type I): Censored regression (Tobin 1958) jointly modeling probability of exceeding threshold and level conditional on exceeding, via MLE.
Tax Morale: Intrinsic motivation to pay tax reflecting civic duty, fairness perceptions, social norms, independent of deterrence.
Revenue Mobilization: Process of increasing domestic tax and non-tax revenue, core to fiscal capacity in developing economies.
IRS publication on Tobit and censored data methods | OECD work on tax morale and informal economy | Tobin 1958 original Tobit reference
Conclusion
Among 350 Kano operators, 37.7% paid zero, average payment ₦4,379.60. Tobit shows income (3,534.13), morale (2,431.97), enforcement (2,249.19), trust (1,461.91), and especially association membership (5,147.96) all significant. Decomposition confirms membership, income, size as largest contributors. Closing compliance gap raises expected average to ₦6,403.13, a 31.6% revenue uplift without sector growth. Policy implication: partner with credible market associations for collection, combine with trust-building and clear enforcement signals, rather than rate hikes alone. Future research should track longitudinal compliance after association-based pilots. For templates, see our complete taxation project materials
FAQs
1. Why use Tobit model for informal sector taxation?
Because 37.7% pay zero, making data left-censored. OLS treats zeros as low values, while Tobit correctly models probability of paying and amount paid as distinct but linked.
2. What is the main finding on trade association membership?
Membership is the strongest binary determinant (β=5,147.96, p<0.001), suggesting community-taxation via associations is most effective lever.
3. How much revenue could Kano gain from better compliance?
Observed average ₦4,379.60 vs capacity-consistent ₦6,403.13 implies about 31.6% potential increase by closing compliance gap.
4. Do ability-to-pay factors matter?
Yes. Business income, business size, and years operating significantly increase payment, consistent with Ability-to-Pay theory.
5. Does tax morale affect informal tax payment?
Strongly. Tax morale, perceived enforcement, and trust in government are each independently significant beyond income.
6. What is McDonald and Moffitt decomposition?
It splits Tobit effect into effect on probability of paying anything and effect on amount conditional on paying, showing unconditional revenue impact.
7. What is the informal sector revenue paradox?
Sector is 40-60% of GDP and most jobs yet contributes little tax, making it fiscally attractive but hard to collect from.
8. What are limitations of presumptive taxation?
Flat presumptive levies ignore ability differences and can be seen as unfair, lowering morale. Association-based collection can improve perceived fairness.
9. Can results generalize beyond Kano?
Partially. Kano’s dense market structure and strong associations aid collection. More fragmented markets like Lagos may need adapted models.
10. What theories underpin the study?
Allingham-Sandmo deterrence model, Ability-to-Pay, and institutional theory/tax morale framework.
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