Political economy of tax reforms—I

Huzaima Bukhari & Dr. Ikramul Haq

The debates and discourses concerning political economy of tax reforms in Pakistan lack objective analyses and rational approach as evident from the latest World Bank Pakistan Raises Revenue (PRR) Project wherein an appraisal paper, it has termed “vested interests lobbying for tax exemptions, internal tensions and wariness of change among the Federal Board of Revenue (FBR) staff, and potential disputes affecting provinces’ readiness to collaborate with the FBR as high-risk factors” for tax reforms. It may be mentioned that the total cost of Pakistan Raises Revenue (PRR) Project is estimated at US $1.6 billion, of which counterpart contribution is $1.2 billion and IDA financing is $400 million.  

In the past as well, World Bank, Department for International Development  (DFID), and others gave a lot of money to Pakistan for reforms, yet things were changed only for the worse on fiscal/tax front. Pakistan Raises Revenue (PRR). Project is purportedly designed to “sustainably increase domestic revenue by broadening the tax base and making it easier for citizens and businesses to pay their taxes. This will make it possible for Pakistan to finance the investments in infrastructure, education and health needed for the country to accelerate and sustain growth”. The lion’s share of huge funding will go in the pockets of so-called foreign experts who have no idea of our mundane realities and rest will be wasted by untrained workforce we have in all tax agencies at federal and provincial levels.

There is yet no research-based study available with World Bank for improving tax administrations at all levels and growth-oriented tax reform agenda. The World Bank in Pakistan Revenue Mobilisation Project has not shown any indication of taxing the rich though rightly noted as under:

Pakistan’s tax revenue potential would reach 26 percent of GDP, if tax compliance were to be raised to 75 percent, which is a realistic level of compliance for lower middle income countries (LMICs). This means that the country’s tax authorities are currently capturing only half of this revenue potential, i.e. the gap between actual and potential receipts is 50 percent. The size of the tax gap varies by tax instrument and by sector. The tax gap in the services sector is larger than in the manufacturing sector (67 percent vs. 46 percent respectively) and it is larger for the GST/GSTS than for income tax (65 percent vs. 57 percent respectively). 

The World Bank in its appraisal report has noted that our tax system is complex because of overlapping jurisdictions with different laws, exemptions, and frequent policy changes. The Constitution assigns income taxes (except for income derived from agriculture), GST on goods, customs duties, federal excises, and the CGT to the federal level. These taxes are collected by FBR. The Constitution assigns the following taxes to the provinces: GST on Services (GSTS), tax on professions, agricultural income tax, motor vehicle tax, urban immovable property tax (UIPT), and other taxes related to real estate (e.g. stamp duty, capital value tax). This tax assignment fragments Pakistan into five markets in the services sector. The withholding tax regime is also problematic because of the administrative burden it places on businesses that are obliged to withhold taxes, and because it distorts economic actors’ incentives.

The World Bank estimates Pakistan’s tax gap at 10% of the GDP or Rs. 3.8 trillion. Our current tax-to-GDP ratio is 12.6% that according to the World Bank should be 23%. Among the 13 federal countries, Pakistan is second to last in the performance of provincial governments on tax collection. While the services sector accounts for 56% of GDP, it contributes only 0.5% of the GDP in taxes and about 11% in sales tax collection.

The World Bank analysis is that Pakistan has a complex tax system of over 70 unique taxes and at least 37 government agencies administering these taxes. It may be recalled that the World Bank in 2004 extended to Pakistan $125.9 million, including IDA credit of $102.9 million and a UK DFID grant of $23 million, for Tax Administration Reform Project (TARP). The objective of TARP was to improve “the integrity and fairness of tax administration by improving organizational efficiency and effectiveness of the revenue administration”. Tragically, tax-to-GDP ratio in 2012, the last year of extended World Bank funded TARP, dipped to 8.2% from 10.6% in 2005 when the programme started! The World Bank in its report, “Implementation, Completion and Result Report” on TARP observed that “the current narrow-base of general sales tax (GST) in Pakistan remained almost entirely unchanged throughout 2005-2012, despite efforts to overhaul the indirect taxation structure by introducing a reformed GST featuring few exemptions and wide coverage of goods and services”.

World Bank in its latest appraisal report has not mentioned mafia-like operations that include amongst others, missing containers, refund scams, smuggling of goods, currency and narcotics, under-invoicing, and abuse of the legal tool of issuing Statutory Regulatory Orders (SROs) to favour the rich and mighty. Pakistan aptly fits in the concept of a “soft state”—famously articulated by the Nobel Laureate, Swedish sociologist Gunnar Myrdal in his 1968 three-volume work, Asian Drama: An Inquiry into the Poverty of Nations. It is a broad based assessment of the degree to which the state, and its machinery, is equipped to deal with its responsibilities of governance. The more soft a state is, the greater the likelihood that there is an unholy nexus between the law maker, the law keeper, and the law breaker.

Pakistan is facing multiple challenges on the economic front: reckless borrowing by successive governments for meeting its day-to-day expenses, lack of resources for rapid infra-structure improvements, trade deficits, fiscal deficit, inflation, balance of payments, and what not. In these challenging times, we have taken more loans, even from World Bank to reform our tax system! Faced with grave challenges to combat terrorism, money laundering operations funding the militants and criminals, and the problem of ever-growing black money, which according to independent experts is about three times of the documented economy, our political leadership and tax officials opted for yet another foreign-funded tax reforms.

The main emphasis of the PTI Government is still not on low-rate taxes on the broadest possible tax base, taxing the rich and mighty through alternate minimum tax and property tax according to the size of the house/office. Along with these measures, it is vital to bridge the monstrous tax gap which according to official claims is not less than 70%, the collection of which is essential as it can wipe out the entire fiscal deficit. This is, however, not possible unless federal government, after consultations with provinces, introduces harmonised sales tax on goods and services and establishes a single agency to monitor all inflows and outflows and document all the transactions relating to acquiring of assets.

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The writers, lawyers and authors, are Adjunct Faculty at Lahore University of Management Sciences (LUMS)