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.

Jawad Shah

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. 

The post What Ails Pakistan’s Tax System? appeared first on Dissent Today.

This short piece goes beyond the immediate multiple crises Pakistan faces on which others contributing to this series have offered thoughts and insight. Some may even be brave enough to present ideas and perspectives which are essential for Pakistan to exist at a level where a predominant majority of the population benefits from public and political action. Some will suggest how many of the chronic problems Pakistan faces today could be resolved.

Observers have been commenting on if/whether Pakistan were to default, what strategies would be required to continue functioning. (There are numerous templates and suggestions where one can look to find answers, although Pakistan’s specific economic configuration, size, location and relationship with many countries will always warrant somewhat different solutions.)

Some have also been asking if there is an alternative to the IMF, and issues related to dealing with International Financial Institutions. Another particularly topical theme on which many would give suggestions, relates to the need for ‘political unity’, or ‘consensus’, where the three or four main civilian political leaders would be advised to ‘sit and talk’ and come up with a strategy to ‘save’ Pakistan – with the military a possible arbitrator to such negotiations and talks. (The contradictions in such an endeavour ought to be obvious to anyone who sees which institutions are mentioned here, being the cause of the problems in the first place.) Issues related to macroeconomics, the Constitution, the ubiquitous climate crisis, and educational and legal reforms are also being discussed by analysts.

Reform and rethinking in all these and numerous other areas is essential, and the status quo cannot continue. For Pakistan to even exist with any prospects of hope and progress, it will have to offer very different possibilities. Avoiding mistakes of the past is important. Some areas which need to be on the agenda for discussion, and if possible, implementation, are presented here.

Neoliberalism’s failure

Perhaps neoliberal policies, backed by global capital, the IMF and the World Bank, work in some countries, where some level of economic growth and stabilisation may have taken place, albeit at huge environmental costs and with increase in inequality. This is a big ‘perhaps’. In fact, one can argue that many years after the failure of the worst kinds of capitalist exploitation under the name of neoliberal economics – the electorate – in many countries, has shunted out governments who supported and endorsed such policies. Latin America’s recent ‘Pink Tide’ offers numerous alternatives.
Moreover, the one-policy-fits-all fails, precisely because not all countries are alike. Pakistan is a good example of such failure, with after 22 IMF programmes, every government insists on starting a new one. This is a failure of every Pakistani government, of the IMF especially, and of neoliberal economics’ generalisations which are supposedly applicable to all, or most, countries.

While Pakistan cannot opt out of the globalised world capitalist system, it can adopt and promote numerous policies which focus on local needs and priorities more than those of global capital. Political leaders will need to take numerous hard decisions to make redistribution instead of accumulation the main pillar of economic policy. Key components for such an economic policy would need to include issues related to: taxation of all incomes regardless of source, taxation which is highly progressive and based on direct taxes rather than indirect taxes, doing away with most tax exemptions and benefits which favour only the elite and the private sector corporations, and similar issues.

A thorough review of expenditure and perks available to public sector employees and interests, including the military, is necessary. A wish list would allow for more spending on education, on promoting the right mix of economic incentives and opportunities, etc.

Income and wealth inequality, with extremes visible, has become a clear manifestation of every economic policy followed under the guise of neoliberalism in Pakistan. A recent UNDP Report found that ‘the richest 20 percent of Pakistanis hold 49.6 percent of the national income, compared with the poorest 20 percent, who hold just 7 percent’. At times of economic crises, as Pakistan faces currently and into the future, such inequality manifests itself in the worst form of discrimination. These policies must change. Trickle-down economics does not work. Land reforms – both urban and rural – better, focussed, distributive policies, all need to be implemented to include the poor and marginalised. All economic and social interventions have distributional consequences which affect different sections of society very differently.

Income and wealth inequality, with extremes visible, has become a clear manifestation of every economic policy followed under the guise of neoliberalism in Pakistan.

Whether a government goes to the IMF or doesn’t, the consequences fall differently on different sections of the population, the well-off, the middle class and the poor, very differently. Distributional consequences need to be factored into every decision taken.

Putting women first

In the literature on development economics and from history, numerous facts emerge repeatedly, which suggest some patterns and allow us to draw some clear conclusions and insights. One such finding is the need to put women first, in every public and private policy initiative. Without the participation, and in many cases, without the promotion and incorporation of women in every activity, countries will not progress. Women are central and foundational to the economic, social and cultural constituents of society and all things which exist subsequently. Every single policy in Pakistan must put women first. From literacy and education, to public safety and making transport available, to ensuring economic rights and opportunities, to providing equal inheritance rights, and rights to choose a spouse or the number of children they want. Such demands are a bare minimum for any collective measure required for the development of women, and ultimately for the progress of the country. At the minimum, equity and egalitarianism in every development and social project, needs to be gender-based. Our analysis of all economic and social issues needs to be based on a clear gendered perspective.

Educating women, giving them more jobs, creating a conducive environment which protects and allows them opportunity for education and financial resources will have huge knock-on effects on the economy and on society overall. From demographic consequences, to acquiring more rights and incomes, educating women will transform the social and economic structures of society and make Pakistan a far better place to be.

Neighbourly relations: An end to no-war, no-peace

Few countries progress or develop – however one wants to define either term – without engaging productively with their neighbours. The academic and anecdotal evidence and literature cites numerous economic and cultural evaluations which underlie this premise. Increasingly, countries are participating in and benefitting from regional trading blocs. South Asia remains the only major region, with as many as 1.5 billion people (twenty percent of the world’s population), which has little trade or economic engagement. The reason obviously is the relation between India and Pakistan.

Neither country is going to (physically or ideologically) move out of South Asia, although Pakistan has unsuccessfully tried for decades to do so. Both neighbours will have to come to terms with different religions, ideologies and political constituents and will have to accept each other’s domestic preferences and work around them. India is expected to be the fastest growing economy in 2023 and 2024, and in 2023, 15 percent of global growth will come from India.

Pakistan, at a time of extreme economic crisis, will be the biggest loser – having lost the opportunity to benefit from and participate in India’s economic boom. Pakistan’s leadership will cry hoarse over India’s internal politics, but this will not help Pakistan’s case. It will have to engage with its larger neighbour and accept that it is the junior partner, but a partner no less, and take South Asians forward. Egos and jingoistic sabre-rattling is not going to help Pakistan. There is an urgent need to rethink Pakistan’s India policy as this has far greater consequences than just possible economic benefits. The entire political economy of Pakistan will change if Pakistan and India can actively wage peace and engage in economic, social and cultural exchange.

Negotiating the military/negotiating with the military

Politicians are as much responsible for bringing the military into power in Pakistan, as the military’s own ambition and its greed and hubris. Pakistan continues to be dominated by the military because politicians have made it easier for the military to do so. Every opportunity that civilian politicians have created to enforce their writ on the political settlement, has been lost, as the military has re-established its writ and hegemony over civilian politicians, essentially due to some politicians (usually the opposition at any given time) reaching out to the military to favour it (the opposition) against the incumbent government.

As long as politicians and civilians believe that the military is their benefactor, it will continue to reign supreme. Pakistan’s military governments are a consequence of the failure of civilian politicians to be able to reach some form of understanding and equilibrium amongst themselves as to how to deal with the military, the so-called ‘establishment’. Individual civilians, in particular, have played a role in claiming ‘same-page-ness’ with the military, and have benefitted as well as suffered, by giving individuals in the military too much importance. While it is easier said than done, civilian politicians need to understand that the military is always a non-democratic force and needs to be kept away from politics. Only a consensus by civilian politicians can do this.

Moreover, it is important to realise that the question of the military’s budget as a share of the overall budget, is not of the consequence it once was, and today the dominance of the military in civilian and economic affairs, is much greater than what can merely be measured as a percentage of GDP. Agricultural land of many thousands of acres given by the government, or the many businesses of the military and real estate assets and connections, are far greater in value than its military budget. The absence (or inability) of civilian oversight and control, allows a severely warped playing field to exist, which hinders civilian enterprise – creating further privilege in favour of an institution which remains outside the control of civilians.

The aforementioned UNDP report shows that Pakistan’s military has ‘the largest conglomerate of business entities in Pakistan, besides being the country’s biggest urban real estate developer and manager, with wide-ranging involvement in the construction of public projects’. Pakistan’s politicians are responsible for this only as much as Pakistan’s military itself.

Conclusion

Neoliberalism’s failure in Pakistan is not simply a failure of the market or of capitalism, but also of those groups and parties which have constituted government and have held power over the last several decades – the elite in their political manifestations. Every political party as well as the military, is equally implicated in Pakistan’s acute failures and to expect the same groups of institutions or individuals to now do things differently, is irrational.

The existing political settlement has completely failed, and collapsed, and new political and class forces will have to capture political power to offer alternatives. An end to Pakistan’s political, social and economic problems can be achieved through different forms and manifestations of collective action since the existing political forces are unable and unwilling to bring about change even when the old order has unambiguously collapsed. This is a minimum requirement which underpins the possibility of meaningful and substantive change or A Way Forward for Pakistan. Otherwise, we repeat, we fail, we repeat again, and we fail better.

S Akbar Zaidi

The writer is a political economist and currently heads the IBA, Karachi, a public sector University. These views are his own and do not represent those of the institution.

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