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Value Added Tax (VAT) in Pakistan

 Analysis of enforcement problems


Dr. Ikramul Haq


The enforcement of sales tax [since 1990 it has been undergoing a gradual shift from General Sales Tax (GST) to Value Added Tax (VAT) type] in Pakistan is becoming more and more difficult and highly controversial, as hostility and antagonism between the Central Board of Revenue (CBR) and the taxpayers over different issues vis-à-vis modes of collection of this VAT-type tax continues unabated.

VAT is a specific turnover tax levied at each stage in the production and distribution process. In its purest form VAT is a tax on all final consumption expenditures for the supply of goods and services. Although VAT ultimately bears on the individual consumption of goods and services, liability for VAT is on the supplier of goods or services. VAT is a percentage tax levied on the price each taxpayer charges for the goods or services it supplies. VAT normally utilizes a system of tax credits to place the ultimate and real burden of tax on the final consumer and to relieve the intermediaries of any final tax cost. VAT is calculated by adopting the applicable rate at a taxable stage to the appropriate taxable base of goods or services; it is then reduced by the VAT (as indicated on the invoices delivered to the purchaser), which directly affects the cost of various elements constituting the price of goods or services. In Pakistan there are substantial deviations from this pure form of VAT (as in vogue in Europe and some other developed industrial societies), because of the exercise of various tax rates, exemptions and concessions for certain goods and services and specific provisions governing importation and exportation. It is therefore not VAT but VAT-type tax in Pakistan.

Before analyzing the problems of its enforcement in Pakistan, it will be useful for the taxpayers and the policymakers to get a brief account of evolution of VAT at the global level. It will give us some concrete basis to determine whether it is suitable for Pakistan at this stage of its development or not.


Value Added Tax is levied on the sellers of goods and services based on value added by their respective units. The base of VAT is determined by value added at a particular stage of production or distribution. Meaning of VAT becomes clearer when it is juxtaposed against conventional turnover tax (excise duty, sales tax), which falls on the total value of the product at each stage of production chain and is called a cascade type tax.

VAT, a fiscal innovation of early 1960s, has claimed worldwide attention as more and more countries are adopting it in varying degrees to reform their system of commodity taxation.

Pursuant to the Treaty of Rome (March 25, 1957), the European Economic Community (ECC) was set up with the primary objective ‘to establish, within the framework of an economic union, a common market providing for healthy competition and having characteristics similar to those of an internal market.’

From July 1, 1968, all customs duties and quotas in the trade between ECC member countries were abolished to move towards a common market with equality of competition as a condition. Following the principle of destination, exports to member countries became entirely tax-free, and imports from countries within the community began to be treated in the same way as domestic production destined for home consumption.

To follow the above policy, two arrangements were made.

1.   Although tax on export of goods as such was abolished, the possibility of taxation of these goods during various stages of their production and distribution still existed. The rules of the new arrangement demanded calculation and refund of tax burden on goods as and when they were classified as exports.

2.   Imports into the country, which had escaped taxation by claiming refund in the exporting country, needed to be taxed in a way which avoided discrimination between them and domestically produced goods which had already faced taxation at different stages. Therefore, it was necessary to replace with a common system the differing systems of indirect taxes that had distorted competitive conditions between the member states.

With the above purpose in view, the Commission of the EEC had set up a Committee under the chairmanship of Professor Fritz Neumark, which submitted its findings entitled Report of the Fiscal and Financial Committee of EEC in 1962. The Neumark Report visualized ultimate acceptance by all EEC countries of all-stage value added tax similar in terms of tax rates, exemptions etc.

Agreeing with the recommendations of the Neumark Report, the Council of Ministers of the six original EEC countries issued two directives dated April 11, 1967 which required the common market states to abolish the existing gross turnover tax systems and to introduce a comprehensive system of value added taxation by January 1, 1970. Value added tax, an offshoot of economic union, therefore emerged as an instrument of tax harmonization in the EEC countries. It was a fiscal necessity in the absence of which the success of common market experiment would have been seriously hampered. In certain cases its adoption was almost a precondition for entry in the common market, e.g. United Kingdom which replaced purchase tax and selective employment tax by VAT with effect from April 1, 1973. Though VAT grew as an offshoot of economic union of EEC countries, it has been adopted voluntarily in many countries as a measure to rationalize commodity taxation.

The levy of VAT in Pakistan was unnecessarily made a controversial issue. This tax was introduced successfully in a number of undeveloped countries without any difficulty. In Bangladesh, Indonesia, Philippines, Thailand and Mauritius VAT was imposed without any difficulty. In fact, it was shortsightedness and highhandedness of the CBR’s stalwarts (sic), which pushed the country towards a tax revolt. Firstly, they never bothered to do any homework before introducing VAT type tax; secondly they never bothered to elicit the opinion and consensus of the business community. They tried to follow the European model of VAT in Pakistan without realising that the same cannot be implemented through a corrupt and inefficient tax apparatus and without proper auditing practices in Pakistan.

The Government of Pakistan, in fact, under immense pressure from the IMF, has been trying to impose VAT, which is neither suitable to our peculiar conditions, nor a model followed by two very developed countries of Asia, i.e., Japan and Singapore. It is pertinent to mention that the CBR did not bother to study as to which method of measuring value addition will be workable and how the taxpayers will be assisted in implementing this rather cumbersome tax in Pakistan. They thought that by just promulgating the law, VAT would be implemented. Perhaps this is the worst example of administrative highhandedness and a best example of the naïve attitude of our tax managers. I am sure that none of the CBR stalwarts is even aware of the following methodologies of measuring value addition under the VAT regime.


The value added at a particular stage is measured by two alternative approaches:

(a)        subtraction method, and

(b)        additive method.

Both these approaches are based on the identity that total sale proceeds of a firm from its output during a given period are equal to the cost of inputs, wages, rent, interest, depreciation and profits. The Sales Tax Act of 1990 lacks this perspective, which confirm my point that the CBR at the time of introducing VAT had no idea about what methodology for implementing this tax would be more suitable in our peculiar circumstances.

Under the subtraction method, value added is measured by deducting value of inputs from the value of output (O-I). If the cost of inputs is deducted from total proceeds, the remainder represents the sum of factor incomes plus depreciation.

Alternatively, additive method adds together various types of factor incomes generated, and depreciation. In practice, subtraction method is considered handier and therefore widely relied upon.

There are two ways to compute VAT according to subtraction method. Under the first method, called the sales less purchases or accounts procedure, the rate of tax is multiplied by the difference of output and inputs, t(O-I). Under the second method, called the tax credit or invoice procedure, the product of the rate of tax and input is deducted from the product of the rate of tax and output, t(O) – t(I). The latter is most common in practice being the system applied throughout EEC countries. The VAT liability of a seller under it is equal to the tax arising from its total sales minus a credit for the tax paid by it on its purchases. The seller charges full tax from his buyer but pays to the government the difference between the tax charged and the one already paid on his (seller’s) inputs. It is now for the CBR to amend the law according to what has been elaborated above. They will have to provide a complete method of VAT-mode accounting procedure. It alone will help all affected by this tax to shift their existing accounting practices to conform to VAT methodology. A sufficient time has to be allowed for this shift as was done in the EEC. However, it is lamentable that the ill-informed CBR officials want this shift to take place in a few months time.


 There are three ways to treat the cost of capital goods whose use in the production process is spread over time.

1.         Since value added is defined as output minus input, it is necessary to clarify whether input includes depreciation of capital goods. One interpretation is that it does, i.e. depreciation (also called capital consumption) is excluded from the value added so that value added reflects the sum of wages, interest, rent, and profits. This is called the income variant approach under which the base for taxation is net value added by each producer. The net value added is defined as gross receipts minus purchases of intermediate goods and depreciation. This corresponds to the concept of net national product in national accounting.

2.         The second approach is to exclude the cost of capital goods from value added instead of granting allowance for depreciation over the life of capital goods, and is called the consumption variant approach. Value added is now defined as gross receipts minus purchase of intermediate products and capital expenditure on machinery etc. Since producers are allowed to deduct their capital expenditures, the base for taxation is restricted to the value of production of consumer goods only.

3.         Lastly, it is possible that the cost of capital goods is not allowed to be excluded when they are initially purchased and no allowance is made for depreciation when they are used in production. Value added equals gross receipts minus the cost of purchasing intermediate goods. In other words, it is the sum of wages, rent, interest, profits, and depreciation. This may be called the gross product variant and is the most comprehensive form of VAT. It corresponds to the gross national product concept of social accounting.

The consumption variant approach permits a firm to deduct purchases of capital goods (i.e. gross investment) while income variant concept allows it to deduct depreciation only. In this sense, the base for VAT is bigger under the income variant than under the consumption variant by the amount of net investment (gross investment minus depreciation).

In brief,

Income variant                    =     Gross receipts – costs of intermediate

                                                   goods – depreciation

Consumption variant          =     Gross receipts – cost of intermediate

                                                   goods – costs of capital goods

Gross product variant         =     Gross receipts – cost of intermediate goods

It is tragic to note that the CBR has failed to take into account this very vital part of VAT mechanism, the result is continuous litigation between the Sales Tax Department and the taxpayers. The Sales Tax Act, 1990 is totally silent about the depreciation factor or cost of capital goods factor in determining the true value addition under VAT regime. It is an established fact that the overwhelming majority of officers and staff working in the Sales Tax Department itself is not aware of even the basic principles of VAT-mode tax. They are just resorting to administrative highhandedness to enforce a law, which even they cannot comprehend!


VAT is a multi-stage tax levied on all stages of production and distribution of a commodity. It is collected in instalments on the basis of value added at each stage of production and distribution of a commodity. It is a comprehensive levy covering almost all production and distribution in its fold. It is different from excise duties which, in many cases, are selective in nature.

Under VAT, each input is taxed only once. Since an input is taxed only once, VAT avoids cascading which is the chief disadvantage of the traditional system of excise and sales taxation. Excise duties, and multi-point sales taxes levied on gross output, tax the same input repeatedly as goods pass along different stages of production. This type of taxation encourages vertical integration of industries, a tendency harmful to the growth of small-scale sector.

Since the cumulative effect of input taxation is absent under VAT, the cost of production increases by the amount of tax itself. Thus, by preventing unnecessary cost escalation, VAT promotes competitiveness of domestic industries in the world market and thereby generates favourable effects on exports. In the Pakistani scenario, the IMF has neutralized this benefit by forcing the government to increase the prices of POL and utilities to ensure that export goods manufactured by the local industry should remain uncompetitive in the international market.

VAT in its ideal and comprehensive form also has the advantage of being neutral as between different industries, techniques of production, and business organizations. Therefore, it does not distort patterns of production and consumption. However, neutrality of a tax is not always desirable particularly in the context of an underdeveloped country like Pakistan, which has to use its scarce resources in the best possible manner.

It can easily be seen from the above account that VAT is suitable to highly industralised countries, whereas the Pakistani policymakers (sic) did not bother to study its repercussions for the local industry and economy. They were more interested to please the IMF to get lucrative jobs and perquisites, no matter if in the process, the lives of the poor became more miserable. .


Among the various limitations of VAT, the following are more common:

·    VAT is levied on ad valorem basis and does not admit of physical output as the basis for tax liability determination. Excise duties may be imposed on ad valorem or specific or ad valorem-cum-specific basis, or even in the form of a compounded levy.

·    Ideally, VAT should be imposed at a uniform rate at all stages of production and distribution so that tax credit claims can be made easily. Excise duties, as also sales taxes, are imposed at different rates depending upon the nature of the commodity taxed.

·    VAT is more suitable under a unitary form of government, i.e. under a single tax authority for commodity taxation. In a federation like Pakistan where different tiers of government enjoy overlapping commodity taxation powers, VAT would be difficult to operate due to tax rivalry and lack of co-ordination among federal and provincial governments.


 The proponents of VAT claim that evasion under it is difficult and minimal. The tax credit method ensures cross-checking of the records of taxpayers through invoices. Buyer firms insist on supplier firms to furnish invoices which help the former to claim tax credit. Since tax liability of a single taxpayer under VAT is only a fraction of the total amount of tax, the incentive for evasion is relatively weak. Even a successful evasion would mean less revenue loss as compared to the one suffered under a system of turnover (excise or sales) tax on gross value.

In spite of the self-policing nature of VAT, the experience of Pakistan is quite contrary where both the taxpayers and the tax officials create a lot of opportunities for evasion and fraud. In fact, VAT in Pakistan has provided unprecedented opportunities for fraud (fictitious claims for refunds) that are not available under other forms of commodity taxation.

The methods commonly applied to defraud the government under VAT in Pakistan include, inter alia, the following.

1.         Use of fake invoices to claim tax credit.

2.         Tax credit claims on purchases for personal use.

3.         Over-reporting of sales of zero-rated goods.

4.         Secret deals between buyers and sellers as regards issuance of receipts.

5.         Formation of fake companies which sell receipts to traders to enable them to claim tax credit on inputs.


In short, the businessmen and corrupt tax officials have proved that even a tax like VAT is as susceptible to evasion and fraud as any other tax. In other countries it succeeded as they had efficient tax machineries capable of cross-checking a large number of invoices through an elaborate computer system, which is a pre-requisite for the successful implementation of VAT. This is precisely what is lacking in Pakistan. The performance of the special auditors appointed under section 32A of the Sales Tax Act 1990 is equally disappointing. In fact, they have emerged as another class of extortionists, who are more interested in minting money than acting as good professionals. The reports prepared by them, where deals were not stuck, speak of either incompetence or arbitrariness. The corruption, which was previously confined to government officials, have now spread to professional bodies, courtesy an ill-advised decision to delegate essential State functions to private institutions, which have their own vested interest and proven record of protecting tax fraud through fictitious audit extended to business houses. It is really a pathetic state of affairs.

Successful enforcement of VAT requires an elaborate system of book-keeping, involving numerous computations, at each level of production and, therefore, may prove very cumbersome for the taxpayers. It calls for additional and efficient administrative efforts to check and cross-check the paperwork done by the taxpayers. VAT requires both a collection and a refund mechanism. Apparently, both collection and compliance costs have a tendency to increase. We have neither good audit practice nor efficient tax machinery and yet the CBR’s stalwarts (sic) are hopeful to implement VAT in Pakistan. They perhaps live in a Fool’s paradise.

The problems of tax administration are very acute and complex in Pakistan. Our tax machinery is one of the most inefficient, incompetent and corrupt in the whole world. Admittedly accounting practices in Pakistan are least developed, partly due to very low literacy rate. It is much simpler for firms to file returns of gross turnover than the value added returns which require, inter alia, accounts of taxes paid on inputs. This problem is further compounded because of the preponderance of small-scale producers and sellers in less developed economies. These constraints deprive VAT of its theoretical advantage of automatic cross-checking to discourage evasion. Lack of proper recording of transactions and the unmanageable number of small taxpayers engages the administration in a futile exercise of hide and seek. This problem can partly be solved by extending the VAT system to wholesale stage only and exempting sectors dominated by small-scale production. For further simplification, VAT may be restricted to the manufacturing stage. Exclusion of retail and wholesale stages would significantly reduce burden on the administration without, at the same time, interfering in the working of the tax since they come at the end of the production chain.

 q.r. Ikramul Haq, a leading international tax counsel, is a well-known author specialising in international tax, press, intellectual property, corporate and constitutional law. Dr. Ikram is Chief Partner of Lahore Law Associates (fax: +92 42 7226953, e-mail: irm@brain.net.pk; website: http://www.paktax.com.pk). He is a member of the visiting faculty of the Institute of Direct Taxes in Lahore. He served for 12 years as Deputy Commissioner of Income Tax. He studied literature, journalism and law, for his Masters and Doctorate degrees. He has written many books on various aspects of Pakistani law and global narcotics trade, some of which are co-authored with his wife, Mrs. Huzaima Bukhari, Additional Commissioner of Income Tax. He has been awarded Doctorate of Law for his research: Tax Reform in Quasi-Constitutional Perspective.

 s.nternational tax Glossary, International Bureau of Fiscal Documentation, Amsterdam, 3rd Edition, 1996, Page 329.

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