This article is part of a series titled “Is There A Way Forward For Pakistan?”. Read more about the series here.
Pakistan once again finds itself in a very hard economic situation, but the gravity of the present crisis is far more serious than any we have seen so far. High fiscal deficits, coupled with overspending over the last decade, have pushed Pakistan into a situation where lenders are unwilling to bail us out unless we make serious and consistent efforts towards fundamental economic reforms. In this article, I focus on some tax policy issues and how we should address these challenges.
Historically, Pakistan inherited a typical British tax collection structure which relied heavily on indirect taxes, collected at import (custom duties) or production stages (excise duties), and income tax collected without self-assessment. From 1996-2001, Pakistan undertook a series of tax reforms which shifted the system to a more “modern” self-assessment-based system. This change necessitated rapid automation and the Federal Board of Revenue (FBR) has done exceptionally well in terms of computerisation compared to many other developing countries. It did get some immediate dividends and tax to GDP ratio increased from 9.8 per cent in 2013 to 13.0 per cent in 2018 before regressing back again.
Despite adopting best tax practices, our tax to GDP ratio has barely managed to stay above 10 per cent against a suggested 15-17% given our spending and debt servicing commitments. Why does this anomaly exist? If we have a reasonable tax collection agency, then what ails us and where do we fail? The answer lies in understanding both administrative and policy measures that we need to consider.
On the administrative side, the biggest issue is to resolve the trade-off between ease of doing business, administrative cost and controlling evasion. For example, in 2005, FBR deregistered thousands of small VAT (called sales tax in Pakistan) registered firms because they paid a small amount of net taxes but required high administrative costs. Many of these firms were registered during the 2000-2001 FBR survey drive which was meant to document the economy. Ironically, both steps were taken under the same political regime. What it essentially did was to use extensive administrative resources for nearly half a decade only to let everyone go.
Five years later around 2010, once again all the focus came back on broadening of tax base. The most important source of ensuring tax compliance and enforcement in the present system is audit. While audits can unearth substantial evasion, most cases do not translate to any substantial recovery because of various factors. Cases go in litigation where they are time constrained, and fill the first or second appellate stage but in later stages, there is no time limit on judicial authority for deciding the case. Even when the case is decided against a taxpayer, they may still go to courts to stop recovery action. This has created a perception among taxpayers that they can get away with anything even when the case against them is very solid. There is not much tax authorities can do here.
But the real consequence of this increasingly slow judicial process is that recoveries in most domestic taxes have fallen to 5 per cent on average.The damage this does to the deterrence value of FBR and its tax collection initiatives should not be underestimated in a tax system based on self-assessment. Considering the revenue pressure that FBR faces each year, it has to make up for this loss and the response is often the introduction of arbitrary taxes in the forms of minimum, final, turnover, withholding taxes etc. In this scenario, FBR is left with very limited measures to increase taxes such as increasing the tax rates. But these are not good policy measures.
Tax policy is based on four principles: (1) Adequate Revenue (2) Vertical and Horizontal Equity (3) Economic Efficiency (4) Low administrative and compliance costs. Adequate revenue principle means that tax rate and base should be big enough to collect adequate taxes. While Pakistan has high tax rates, its tax base needs expansion. Retailers and small businesses largely remain out of the tax net, often paying a small turnover tax which is hardly verifiable through any third party. Recent POS retail receipts system is a good initiative to bring these retailers into the tax net.
Agriculture sector is another example of an untapped tax base. The policy initiatives to tap the tax base in the informal economy need long term commitment from political stakeholders that they would not compromise the national economy to appease their political base. Pakistan’s present tax structure performs poorly against the equity principle. Horizontal equity demands that people who have the same income pay the same taxes. Vertical equity requires more proportional payment from high earners than low earners. Over reliance on indirect taxes and withholding taxes implies that low-income people who spend most of their income on basic consumption goods end up paying proportionally more than higher income persons.
Similarly, when some people pay their taxes such as salaried persons and similar income people in self-employment or informal sectors do not, then equity is compromised. Over the last decade, Pakistan has established some good social protection programs like BISP or Ehsaas to mitigate poverty and make its tax and transfer system less regressive. But this certainly is not enough because most middle-income households are left out of these programs.
To increase equity in our tax system, we should follow the simple principle of taxing inelastic but non-essential goods at a higher rate. Recent extra levies on cigarettes and luxury goods are a right step in this direction. However, we need to do more to figure out ways to tax income in exempt and informal sectors. In terms of administrative and compliance costs, Pakistan is not very different from other developing countries because it follows a taxation system which is similar to other developing countries. However, the basic issue that critically ails our tax and transfer system is lack of economic efficiency.
Economic efficiency implies progressive taxation of income, very high taxes on economic rents, consumption taxes with a transfer program that makes them less regressive, and a competitive business environment. Clearly, we have a tax system which fails to achieve these basic goals. Most corporate taxes come through alternative minimum taxes based on turnover instead of profits. But we failed to sign OECD’s Pillar 2 global minimum tax, which is a minimum tax on profits of corporations with top up tax below 15% going to the host country, in this case Pakistan. Seemingly, there is no valid reason for not doing it and 140 countries have joined it. An immediate step could be to join these initiatives which now have a stronger chance of being implemented than ever before.
On the personal taxes front, we may begin with national insurance taxes. They can be a good instrument of bringing informal sector employment to the formal sector. They can also assure long term social protection commitment to a bulging young population. Because these taxes are paid by both employers and employees, they may pressure informal employers to pay extra and hence increase the burden on the informal sector. At the same time, they can make formal sector employers contribute more to the welfare of their workers. Because these taxes are tied to individual transfers in the future, they also make the system more progressive.
The most important element of modern tax policy is to make the business environment economically neutral or competitive. It means that taxes should not distort choices of individuals and firms. Tax on real income or profit is economically neutral provided that it is not easy to evade. Unfortunately, tax evasion for firms operating under the profit tax regime is as high as 70%. This necessitates alternative minimum turnover based taxes. It preserves government revenue by taxing those who may be in a loss at the cost of sparing those who made windfall profits.
Audits do not translate into recoveries but even if they did, firms resort to excessive profit shifting strategies which shifts their profits to offshore tax havens. This puts smaller and new firms at a disadvantage –resulting in loss of productivity, innovation, and competition. Similarly, high evasion in indirect taxes allows evaders to lower their prices and drive honest businesses out of the market. Ease of doing business and ease of doing evasion cannot go together. This phenomenon is costing billions of rupees in lost revenues and discourages compliance. Seemingly, it is a vicious circle. So where do we start?
First, we must decide whether we need a territorial jurisdiction system or not. Territorial jurisdiction system in tax administration has its merits but sadly its demerits in Pakistan are now too grave to ignore. If we switch to a non-territorial system, it will take away unnecessary pressure on the revenue target which, ironically, is almost always achieved. We can then focus on more systemic issues and insulate our tax machinery from social pressures and corrupt practices that come with having a jurisdiction based on geographical area. It may also help in reducing the size of tax administration and make it more efficient. In countries like the UK and USA, field offices are small and only for providing basic services to taxpayers while substantial revenue related work is handled on a functional basis.
Second, we should introduce a monetary reward system for the workforce based on the amount recovered. Presently, recovery from defaulters does not translate into any benefit for those who made efforts to recover the amount. A better system to recover taxes from defaulting firms should be made, a system which makes recovery a priority is essential to a self-assessment-based system. Third, we should exercise due diligence and care in new registrations of firms. Many VAT firms turn out to be mere invoice mills and do not do any real business. Without compromising ease of doing business principle, we can allow a provisional registration online and make the permanent registration contingent on physical verifications and meeting certain other criteria.
Fourth, personal income tax return filers do not receive their refunds automatically. If the return is accepted automatically then refund payment should also follow especially when it is small and straight forward verifiable. It would encourage people to file returns. Short term focus on revenue figures results in long delays and complex refund procedures.
Once we have a more focused system in place, then we can go for increasing the tax base. Presently, a 3% further tax is levied on any supplies made to the informal sector by non-retailers over and above the standard sales tax rate of 18%. Even this extra turnover tax has failed to dent the informal sector. Government should go a step further and impose another 3% as withholding tax. It might seem high but why should we not tax the informal sector at a higher rate? We are already imposing higher taxes on non-filers which should also be the case here.
Another right step would be to map all business locations. Businesses, whether they are required to be registered or not under tax laws, should still have a firm registration number linked to a particular verifiable postal address. Operating any business without such registration should be unlawful. This would help in documenting the economy and ensure that we have a record of people who are working in these small businesses. It would be helpful in implementing a national insurance system which can account for the national workforce. Exporters are currently taxed at 1% of their turnover. It should be converted into a minimum tax from final tax so that those exporters who are earning large profits should pay their due share of taxes.
In short, there are some important measures that we can take to streamline our tax system and generate more revenues from the appropriate base. These measures are not exhaustive and are meant to provide a way forward for developing the country in a global competitive environment.
The writer is a Research Fellow in Economics at Oxford University Centre for Business Taxation, Said Business School. He is also a civil servant who is affiliated with the Federal Board of Revenue, Pakistan for two decades. His recent research focus is taxation in developing countries.
