Small business tax behaviour has received surprisingly little attention. We argue that an organizational capability perspective using microfoundations will allow us to better understand the relationships between different drivers and the dynamics of small business tax behaviour. This study draws on in‐depth interviews with 42 small business owners who are matched with the firms’ factual tax compliance status. Using grounded theory, we build a framework that (a) identifies different microfoundations of small business capability to manage tax and (b) explains the dynamic nature of the relationship between organizational capability and compliance. Findings suggest that high capability does not necessarily translate into high tax compliance and this relationship is mediated by the owner‐managers’ perceptions of taxation as well changes in the economic and regulatory environment.