How can Nigerian states make more money?

By now, you probably know the Nigerian federal government is broke.

This year, the federal government’s budget deficit is ₦9 trillion, as it planned to spend ₦17 trillion while it hoped to earn ₦8 trillion and borrow to fund the rest of the budget. What’s worse is that it now earns less than it needs to pay the interest on its loans. 

When this happens, the government struggles to meet other obligations like paying salaries and improving human capital in the country. It’s difficult to see how the government will meet ASUU’s demand of ₦1 trillion when it earned just ₦1.3 trillion between January and April this year and spent ₦1.9 trillion paying back interests on loans. 

The lack of federal government revenue doesn’t just affect the FG’s budget. It also impacts how much allocation goes to the states. Without sufficient revenue going to the states, they can’t pay salaries, fix roads or improve the primary and secondary healthcare centres in their states.

In this article, we’ll focus on solutions, particularly how states can thrive and earn more regardless of the FG’s fiscal situation.
 

How does Nigeria make money?

Nigeria largely earns its revenue in two ways: oil and non-oil. 

Oil revenue (mostly from crude oil sales proceeds) depends on crude oil price and quantity produced. The price, which we largely have no control over, is based on demand and supply in the crude oil market. However, we decide how much to produce within the limit set by the Organisation of Petroleum Exporting Countries(OPEC).

On the other hand, Non-oil revenue is more predictable and depends highly on how the economy is faring. So ideally, when an economy is growing, businesses are thriving, and people are earning income, the country has the potential to earn more from taxes. But it takes more than a growing economy. The country must have a structure to collect the taxes. 

The government recognised this, which was why the Federal Ministry of Finance enacted a finance act in 2018, 2020 and 2021 to squeeze out as much taxes as it could from the Nigerian economy. They did this by increasing Value Added Taxes (VAT), Company Income Taxes (CIT), and imposing sugar taxes, telecoms taxes and more.

And this has yielded good fruits. In the last ten years (between 2011 and 2021), the tax revenue in Nigeria has increased from ₦1.7 trillion to ₦5 trillion. This is the highest we’ve ever seen. Given the increased inflation rate,  ₦5 trillion in today’s income is worth less than ₦2.5 trillion in real terms (2011 terms), which further emphasises why the government needs to increase its revenue significantly.

However, this increase in tax revenue was done when GDP growth was low in the country. Imagine what would happen when there’s sustained high economic growth. 

While the government should be commended on its efforts to improve income in the country, there’s still so much more that can be done to improve revenue through taxes. Currently, most of the tax revenue earned by the FG comes from corporate income taxes, VAT, and other trade taxes, not from personal income tax, because they are earned by the state governments.

Given that personal income tax (PIT) is the primary source of revenue for many developed countries, we’ll be exploring Nigeria’s current PIT structure to see if there’s potential for more revenue. 

What is personal income tax?

But before analysing how much Nigeria could be earning from taxes, what are personal income taxes, and how are they beneficial to the economy?

Personal Income Tax (PIT), as the name implies, is taxes charged on individuals’ incomes. This tax, which is usually progressive—charging higher taxes on people who earn more—is good for redistribution of income and essential to government revenue.

Nigeria currently runs a state-led Pay-as-you-earn (PAYE) and direct assessment system where each state has an Inland Revenue Service (IRS) that collects taxes from residents in that state. PAYE is where individuals working in organisations are taxed based on their income, and the income is remitted by the organisations on their behalf. Direct assessment, however, is income tax charged on the incomes of the self-employed.

Like most countries, Nigeria practises a progressive PIT system which is charged on the annual revenue of each individual. Therefore, the more you earn, the more you’re taxed. 

However, the personal income tax in Nigeria has a liability threshold of ₦30,000 per month. Meaning, Nigerians who earn the minimum wage of ₦30,000 monthly or less are exempted from paying taxes. The whole idea of this threshold is to relieve the poorest individuals from taxes, so they can use their income to meet their basic needs because if they were to pay their taxes, they might have little or nothing left.

Also, PIT is charged on a person’s income less premiums paid on pensions and most life insurance plans except deferred annuities. A deferred annuity is a type of life insurance where an individual sets aside money for their life insurance, but if the person lives to a certain age, they can withdraw the money, and if not, the money is given to their heirs.

Another provision by the finance act is that personal income taxes are to be charged on non-residents working remotely for Nigerian companies or companies with Sufficient Economic Presence (SEP)  in Nigeria. However, SEP has not been defined yet.

Finally, the interests earned on investments in bonds issued by the federal, state and local governments and by corporate organisations in Nigeria, are tax-exempt.

You should now have a picture of PIT works, especially in Nigeria. So, let’s talk about how PIT fits into states' revenue puzzle.
 

How much do states earn from PIT?

States’ revenue is primarily generated from taxes: personal income tax, road taxes and other taxes, with the chief being the PIT. In 2020, Personal income taxes (PAYE and Direct assessment) made up 68% of the total revenue generated by states. In some states, PIT makes up the majority of their revenue. For instance, the FCT earns over 90% of its revenue from PIT. 

However, the revenue many states earn from PIT (and their internally generated revenue) is nothing compared to the FAAC allocations they earn monthly. Only Lagos and FCT actually earn more from PIT than their FAAC allocation. So, for many states, given that they already earn the bulk of their revenue from the federation account, there’s no incentive to increase taxes within the states; but we’ll get to that later in the article.
 

This is further heightened from the table above. Imagine how a state like Gombe will function without FAAC, which is 13 times more than it earns from PIT and 5x its total IGR. It’s even worse in a state like Bayelsa, where 90% of its 2020 internal revenue was from PIT,  which was ₦11 billion, whereas it collected over ₦110 billion in FAAC allocation. With 10x its revenue coming from FAAC, there’s no incentive to earn more domestically.

So, it’s not surprising that Nigeria is earning little from its PIT. But is that the norm across other countries? Let’s check.
 

Nigeria is not earning enough from PIT 

There’s no theoretical framework to know if a country’s tax revenue is ideal. Still, one way to know if the country is maximising its tax revenue is by comparing it with similar countries. Using this framework, we see that Nigeria isn’t earning as much as it should from personal income taxes. In 2020, the personal income taxes (PAYE and Direct assessment) was about ₦888 billion, which was about 0.5% of Nigeria’s GDP. Whereas personal income tax remains a major source of revenue for several developed countries like Canada, the US and Denmark, where they earned them as much as 12%, 10% and 24% of their GDP, respectively.

Compared to our African contemporaries, there’s still room for improvement. While Nigeria earned 0.63% of its GDP from PIT in 2019, South Africa and Rwanda earned 9% and 5%, respectively. Even though Nigeria’s GDP is much larger than these countries, the revenue as a percentage of GDP shows us that these countries can earn more PIT from their economies than Nigeria. 

PIT is directly correlated with economic growth. The more a country or state grows, the more they can earn from PIT. But, the state's tax is limited to how much its residents earn. 
 

Likewise, the richer the residents of a state, the more they can earn for that state. From the graph above, we can see that there’s an inverse relationship between poverty headcount and personal income tax. The poverty headcount here measures the percentage of people living below the poverty line in a state. Ideally, a state that has many people living below the poverty line—earning less than ₦9,480 monthly—would not earn much income on PIT except the inequality in the state is stark. That is, the people living above the poverty line are much richer than those below. 

From our chart above, we see that the states in the top left quadrant have high poverty headcount rates and low PIT—a typical scenario. However, some have low poverty headcount rates and are still earning low PIT. Let’s look at their income to understand why this is the case. 
 

From our income table above, there are only 12 states with an average income above ₦30,000. This means we have different categories of states. Class A: those with low poverty and high income from PIT because the average income is high, like Lagos and Abuja. Class B, with low poverty but don’t earn enough PIT because the average income is low, like Oyo and Osun, they could also have a large number of people working in the informal sector, whose incomes are not accounted for. The third class, C, has high poverty headcounts and low PIT because the average income is low, like Taraba and Yobe. Class D has high poverty and low PIT even though the average income is high like Zamfara, which probably has high inequality rates and cannot extract enough taxes from the rich few. 

Likewise, states like Bayelsa, which fall under class E, have low poverty rates, low PIT earnings, and high income because of the states' inequality. Even though the average income is high, it is concentrated in the hands of a few, which is why the state earns little revenue from PIT.
 

The work to earn more taxes

Each category will have to collect taxes differently, given the peculiarity of their states. So, what can they do to increase taxes in these states?

Well, the first thing is to increase incomes by getting people to work more or engaging them in more productive work. 

As a country grows, the economy creates more formal and productive jobs, where people can earn and generate more revenue for the states. Currently, Nigeria’s economy is not very productive, as over 70% of the economy is employed in the agriculture sector, which is largely informal and subsistence, generating low income for the country. But this is not peculiar to Nigeria. Many emerging economies have large informal sectors. 

States like Lagos and the FCT earn more PIT than FAAC because these states have a large concentration of formal companies like multilateral organisations and government parastatals. This means people there have higher-paying jobs than those in other states. 

Also, the presence of these corporate organisations informs how the taxes can be collected. Remember that PAYE is collected through companies.  So, naturally, states with more formal organisations would earn more taxes because of the structure. Also, the larger the companies, the more they’ll probably remit to the government.

So, it’s not shocking that the states at the top left quadrant of the poverty vs PIT graph are predominantly farming states. Farming in Nigeria is typically informal, which means the income might be inconsistent and difficult to track, so taxes from such activities are also hard to track and monitor.
 

Implementation is the real issue 

Tax collection is an expensive and tasking job to do, especially in states where informal commercial activity is predominant. 

There are many issues relating to poor tax collection. These issues are largely divided into two segments: the capacity of the states’ tax collectors and the willingness of the tax collectors to pay the taxes.

Capacity for tax collection here refers to the ability of the collectors to monitor and ensure tax collection adequately. For states to collect taxes adequately from their residents, they must first know how many people live in that state, how much these people earn, where they live and do business, who they do business with, and much more. This information would help them know how much the taxes are, what taxes they can collect and how to penalise people if the taxes are not paid when due.

It’s easy to charge a person who earns a steady income from one source every month, compared to someone who earns from multiple inconsistent sources.

A school teacher who earns a salary every month, and receives the same in her bank account every month, is easy to rope into the tax bracket. In fact, her employer would already deduct the PIT from her salary before remitting the net income to her at the end of the month. When the taxes are not deducted from her salary, the government can penalise her organisation for not remitting taxes when due.

However, for someone who takes on several jobs like working on a farm for a few months or working as a labourer, it’ll be difficult to trace the person’s income and charge the right amount of taxes. How do you differentiate between money paid for work done and money gotten as a gift from a friend? 

In this case, the government introduces presumptive taxes, a form of anecdotal assessment of how much a person’s tax should be. Currently, Lagos, Kwara, Rivers, Ogun and Kaduna states implement these presumptive taxes on the informal sector in their states. For instance, Kwara state introduced this for market traders and artisans, charging a flat rate of ₦1,500 per annum through the work cooperatives and associations. With the structure for collection in place, the states must go the extra mile to ensure the collection is free of fraud and the taxes get closer and closer to being reflective of the actual taxes that should be charged.

Likewise, it's much harder for someone with foreign and domestic investments to track what is an income, what is a gift and what is a loan. This is where the state governments need to focus on improving their tax implementation. It’ll take conducting audits of the inflows of capital and interest payments from investments abroad and locally and even closely monitoring the flow of funds.

Beyond monitoring how much people earn, part of equipping the tax collectors with the right skills is ensuring they have the power to penalise people. So while the government monitors people through their organisations and associations to ensure they pay their taxes, they support the monitoring with adequate strong enough penalties to ensure tax compliance.

Also, as I explained earlier, states earn more of their revenue from FAAC allocations and not necessarily from income generated within the state. Hence, for states with high poverty rates, there’s little or no incentive to chase after taxes within the state, especially if the cost of tax compliance is higher than the expected taxes.
 

Trust helps

But even if the mechanism for tax collection is solid, the taxpayers themselves have to feel like they’ll receive value for the tax paid through the government holding its end of the social contract.

Based on research done by the World Bank for the Kaduna state government’s attempt to reform tax collection in its state, improving tax collection in states relies heavily on the state’s ability to earn the taxpayers’ trust. But the state also laid down structures to improve tax collection, such as introducing presumptive tax for the informal sector, automating the tax collection, centralising taxes and much more.

Trust is built when taxpayers feel like the government is holding up its end of the social contract when taxpayers pay and know their taxes are being used appropriately for projects that’ll benefit them. Also, trust comes from equity in tax payments. The reason why taxes are progressive is for wealth distribution. If the poor feel like the weight of taxes is more on them than the rich, they tend to evade taxes.

Personal income taxes, as we’ve shown already, come from a country or state, maximising the income generated within the state or country.

From a comparison with other countries, Nigeria has the potential to earn more from its taxes.  However, states need to develop the will and create the opportunities that will help them to achieve this. If there was ever a time to improve taxes, it is now.