Tax Reforms: Needs & Challenges
Dr. Ikramul Haq
There is a national consensus that existing tax policy needs to be reformulated to provide an equitable, pragmatic, investment-oriented and business-friendly tax system, integrating good tax administration with simplified tax laws that are easily to be understood and hassle-free from implementation perspectives.
This article presents some important tax policy imperatives to initiate a public debate aimed at helping the policymakers to formulate a rational and workable policy framework. The recent efforts of the government to reform the tax system through a special Task Force, reports are which now lying with the Finance Minister, have not attracted a countrywide debate or a warm response. It remained a bureaucratic exercise with no meaningful dialogue with the people and experts who matter in the subject. In the absence of a well-designed tax policy, the agenda of tax reform will remain lopsided. The government should not make any legislative and/or administrative changes till the time a transparent tax policy is announced and support of all those who are affected by it is secured.
Over the period of time our tax system has become rotten, oppressive, unjust and target-oriented. There is a dire need to discuss the philosophical framework and principles that should be the main concern of our tax policy and not mere achieving of targets set out unreasonably by the foreign donors. Our potential is much higher than these targets, which we can never be able to achieve with the present tax laws and incompetent, inefficient and corrupt tax machinery. All efforts to bridge the ever-increasing revenue deficit during the last 54 years have miserably failed.
We should get ourselves free from the figure game of the IMF. The existing tax policies have failed to reduce the fiscal deficit, and on the contrary are destroying our industry and business. If we manage to formulate a rational tax policy and implement it through consensus and not coercive measures, there is every possibility to get rid of IMF in a short span of time. However if we keep on following their prescription, we will neither realise the fixed targets, nor achieve the cherished goal of self-reliance through resource mobilisation. Our tax potential is not less than Rs. 800-1000 billion provided the tax base is made wide and equitable, tax machinery is completely overhauled and exemptions and concessions available to the privileged sections of society are withdrawn.
The tax bureaucrats fully conversant with the working of their machinery, which itself is the main cause of huge revenue leakage, left with no choice but to adopt shortcuts to show higher collection figures by resorting to presumptive taxes (with yearly increase in their rates) and criminally withholding refunds that were created but delayed or blocked for a long time. They also fudged their books by inflating tax collections resulting into payment of fine by the government to the IMF. The taxpayers have also lost faith in the system. Once a system loses its credibility even the right measures cannot be enforced. This is exactly what has happened to our tax system. The promises made by the State were never kept. Unpredictability and inconsistency have been the key words for the policymakers while devising tax policies. It is therefore not surprising that the taxpayers and the investors have become highly disillusioned.
The policy imperatives discussed in this article are prerequisites for any meaningful change in our tax system. In case we fail to determine a rational tax policy any attempt to reform tax administration or make legislative changes in the existing tax laws will be either futile or even counterproductive. It is, however, necessary that tax policy should be debated on national level, consensus of all who are affected is sought and be adopted through a democratic process. Needless to emphasize that unless this procedure is adopted its implementation cannot be ensured, no matter how good such a policy may be.
The basic principle of a sound tax policy should be to tax the people on the basis of their ability to pay and not in a ruthless manner as is being done presently; e.g. a rich person earning Rs.2 million per annum as profit from bank deposits pays Rs. 200,000 as tax under presumptive regime, whereas his normal tax liability comes to Rs.616,000. He is getting a net annual tax benefit of Rs. 4,10,000 since 1991. In contrast, a widow, who is earning just Rs. 30,000 per annum from her deceased husband gratuity kept in bank to make both ends meet, has to pay Rs. 3000 as tax although her income otherwise is below taxable limits. Can this kind of tax system inspire people to pay their taxes honestly and diligently?
If a given amount of revenue is needed to finance public services, then each taxpayer should contribute in line with his ability-to-pay taxes. Those who possess more economic power (income and wealth) should contribute more to public exchequer and vice versa. The duty to pay taxes is seen as a collective responsibility rather than a personal one. The ability-to-pay principle views tax policy issues in isolation to incidence of public expenditure. This principle is regarded by many as the most equitable and just method of taxation. It is emphasized primarily for its redistributive role. We in Pakistan have completely deviated from this principle, which is constitutional obligation of the government.
For implementing the ability-to-pay rule, it is necessary to know as to how this ability is to be measured. Should ability-to-pay of an individual be identified with his income, net wealth, family size, health status of family members or some combination of these and other factors? And if a combination is to be considered, how to decide the relative weightage to be assigned to each of the various factors? Formidable problems arise when two individuals with equal incomes but unequal wealth or equal wealth but unequal incomes are considered. More serious problems arise when individuals A and B have unequal incomes and unequal wealth in such a way that A has more income than B and B has more wealth than A. How is the inequality of income to be adjusted against the inequality of property? In short, the question is how should people with differing abilities be treated for the purpose of taxation? We have to follow Quranic injunctions in this regard which unambiguously and unequivocally command us to spend in Allah’s way whatever is surplus after the fulfillment of one’s legitimate needs [2:219]. There is no room of concentration of wealth in a true Islamic society.
It is simple that taxpayers with equal incomes should pay the same amount of tax. This is called horizontal equity, i.e. taxpayers in similar economic circumstances should bear the same tax burden, economic circumstances being defined in terms of level of income. The second aspect of ability-to-pay rule is vertical equity, i.e. taxpayers in dissimilar economic circumstances should bear dissimilar tax burdens. Thus, persons earning more should pay more tax than those, earning less. This is the essence of Quranic commands, which the State is bound to follow under the Constitution of Pakistan while formulating tax laws.
The ability-to-pay rule is based on the Quranic philosophy that tax burden on individuals should be so distributed as to force them to make ‘ equal sacrifice’, being defined as loss of utility or satisfaction by surrendering units of money as tax.
The equal sacrifice rule, associated with such distinguished economists as J.S. Mill and A.C. Pigou, is based on the following assumptions:
- It is possible to relate units of income with units of utility.
- The utility curve for income has a downward slope, i.e. marginal utility of income varies inversely with income.
- The marginal utility of income curve is the same for all individuals.
Under these assumptions, the equal sacrifice rule is clear for taxpayers with equal incomes. They should surrender equal amounts as tax which in turn means sacrificing equal units of utility (horizontal equity). However, difficulties arise in interpreting equal sacrifice rule for people with different incomes. How is the term ‘equal’ to be understood? In the tax literature the following interpretations of the equal sacrifice rule are found.
- Equal Absolute Sacrifice. It means the number of units of utility taken away from each taxpayer should be exactly the same.
- Equal Marginal Sacrifice. The marginal sacrifice is the same, i.e. utility left with, rather than taken from, every taxpayer after tax should be the same. This will ensure minimum total sacrifice for society, and hence it is also called Least Aggregate Sacrifice Principle.
In short, determination of a tax base capable of measuring an individual’s ability-to-pay is a major problem of our tax system. This rule is incorporated in the form of progressive rate schedule for personal income tax, estate duty, and property tax worldwide. In Pakistan we have moved from this policy to unequal sacrifice rule where the mighty civil and military bureaucrats (now they are part of the landed aristocracy by getting State lands as awards and rewards), rich industrialists and greedy businessmen are paying meagre personal taxes and the poor people are compelled on the directions of the IMF to pay GST of 15% [16.5% in case of non-registered persons] and ever rising costs of public utilities and POL products. This is a clear violation of Quranic injunctions and the government must immediately remove these dichotomies. The taxes should be for the welfare and benefit of public at large and to make the State invincible, and not for the luxuries of the rulers and State functionaries.
According to this principle, an equitable tax system is one under which tax payments are based on the amount of benefits received from government services. In other words, the cost of government services should be apportioned among individuals according to the relative benefits they enjoy. Clearly, implementation of the benefit principle presupposes determination of the incidence of public expenditure before deciding distribution of tax burden. Thus it encompasses issues of both tax and expenditure policies.
Our successive governments have failed to convince the people that payment of taxes is their collective responsibility. All the civil and military governments alike were engaged in wasteful expenditure, never bothered to live within their means and failed to even protect the life and property of the people, not to talk of providing them basic needs of health, education and civic amenities. Are they justified to ask people to make sacrifices when the life style of the rulers is shahana (Emperor like)?
Tax policy should be used as a tool of distributive justice. The Government should launch programmes, financed mainly through taxes, to solve the twin problems of unemployment and poverty. These welfare-oriented schemes may also include subsidized/free medical and educational facilities, low-cost housing, and drinking water facilities in rural areas, land improvement schemes, and employment guarantee programmes. Once people see the tangible benefits of the taxes paid, there will be better response to tax compliance. Taxes cannot be collected through harsh measures and irrational policies. The rulers and tax bureaucrats have to demonstrate by their actions a clear inspirational model for the taxpayers to believe them and to pay taxes honestly and diligently.
Assignment of Tax
Assignment of a tax means transfer of taxation power form a higher level to a lower level government. Taxation power includes the following: right to levy the tax, collect the tax, and appropriate the proceeds from the tax. Thus, there can be three interpretations of assignment of a tax. Firstly, higher-level government may levy and collect a tax but handover the entire proceeds to lower level governments. Secondly, the higher-level government may levy a tax but allow the lower level governments to collect it and retain fully the proceeds therefrom. Finally, the higher-level government may transfer a tax to lower level governments, a situation which defines assignment of a tax in its strictest sense.
In the Pakistani scenario the opposite and worst has happened. The federal highhandedness in tax matters (by using both federal and concurrent lists) has destroyed the financial and economic rights of the provinces. The provinces have the exclusive right to levy taxes on goods and services within their respective physical boundaries, but the Federal Government blatantly encroached upon their undisputed right by levying tax on goods and services under sections 80C, 80CC and 80D of the Income Tax Ordinance. Such taxes are no more taxes on income (which the federal government is empowered to levy under item 47 of the Federal List) but tax on goods and services. It is a great tragedy that this argument was not addressed in the Supreme Court when the constitutionality of these provisions was challenged and the matter only revolved around academic discussions over the concept of income. If the Federal Government can treat even tax on goods and services as tax on income, as upheld by the apex court per incuriam, then what will be sanctity of division of fiscal powers provided in the Constitution of Pakistan.
Generally, the purpose of tax assignment is to augment the resources of lower level governments. The assignment of tax may be conditional. Thus, it may be obligatory on the part of a lower level government to levy the tax assigned to it. Not only this, the lower level government may not have powers to alter the basic structure of the assigned tax. It may enjoy flexibility in fixing the tax rates within a minimum and maximum rage prescribed by the higher-level government.
There is an urgent need in Pakistan to reconsider the equitable distribution of fiscal and taxing powers between federation and the provinces. The true provincial autonomy can only be guaranteed if assignment of tax principle is followed in letter and spirit. By just electing some people under the local body elections and asking them to dislodge the District Management, provincial autonomy cannot be extended. Let the provinces have exclusive right over their resources and finances. Let us transfer taxes to local governments so that grass root democracy and funds for public services can be guaranteed.
Buoyancy and Elasticity of Tax Revenue
Tax revenue may change through automatic response of the tax yield to changes in national income and/or through the imposition of new taxes, revision of the bases and/or the rates of the existing taxes, tax amnesties, stricter tax compliance and other administrative measures backed by legal action. Changes in the tax yield resulting from modifying tax parameters (bases, rates etc.) are called discretionary changes. Variations in the tax yield flowing from the combined effects of automatic responses as well as discretionary changes constitute the buoyancy of a tax. It is computed by dividing percentage change in tax yield by percentage change in national income.
The Pakistani experience in this regard has been very disappointed as admitted in the following paragraph:
“Although successive governments have made attempts to narrow the revenue-expenditure gap by taking new fiscal measures in the federal budgets, little improvement has taken place in the overall fiscal deficit. Why is it so? Pakistan tax system is still characterized by a narrow and punctured tax base, over reliance on distortionary import-related taxes, high taxes on the one hand and tax concessions and exemptions on the other, and weak tax administration. The combined effect of these structural weaknesses resulted in low and stagnant tax-to-GDP ratio on the one hand, and tax elasticity and buoyancy on the other. Such a tax system has severely hampered resource mobilization efforts in the past despite a series of discretionary measures taken in almost every federal budget to reduce the widening gap between revenue and expenditure” (Economic Survey 1999-2000, Page58).
This is the most apt comment about our rotten, unjust and oppressive tax system and an open official admission that efforts to bridge the ever-increasing revenue deficit during the last 54 years have miserably failed. In every federal budget, the tax bureaucrats made mindless amendments in tax laws with the singular aim of achieving TARGETS set out by their bosses in the Ministry of Finance, under the dictates of the International Monetary Fund (IMF) and other donors. These targets were not impossible to achieve (as usually projected by the CBR stalwarts to conceal their own incompetence), but these could not be realised due to corrupt, inefficient and incompetent tax machinery
Buoyancy estimates assess the overall success of government measures to increase tax revenues while elasticity coefficients indicate the inherent responsiveness of a tax system to changes in national income. In the absence or weakness of elasticity attribute of the tax system, a government will have to revise tax rates and tax bases every year to keep the share of tax revenue in national income undiminished. Such frequent changes complicate tax laws, reduce administrative efficiency and are also politically inexpedient. This is what happened in Pakistan for the last 54 years. It is the high time that we must have a paradigm shift in out tax policy to avoid these kinds of negative effects. Therefore, tax structure should be so redesigned as to impart reasonable degree of elasticity to the tax system.
Taxation is a potent instrument to shape and influence the socioeconomic polices of a country. It is, therefore, imperative for us to formulate a nationally acceptable tax policy keeping in view our own peculiar conditions and not by taking dictates from the IMF and other donors, who are suggesting what suits to their vested interest. Our Tax policy must take into account:
- Present stage of our economic development.
- Objectives of economic policy.
- Priorities of economic policy continually change with the changing economic, social, and political milieu.
New tax policy should entail the following three functions:
- Resource Mobilisation. The first and foremost objective must be to raise resources for public authorities for administration and development. Taxes are the main instrument for transferring resources from private to public use. By designing an appropriate tax structure, resources can be raised from those who are holding them idly or squandering them on luxury consumption. According to Roy Gobin, “ the revenue criterion is usually the dominant consideration, since governments in LDCs have become increasingly aware of the active role which budgetary measures can play not only in initiating and promoting growth but also in maintaining political power. Not only are higher revenue levels needed, but also tax yields should be increased at a faster rate than income, if infrastructural investments and social welfare expenditures are to be financed without generating unacceptable inflationary pressures and/or increasing reliance on foreign assistance.” The revenue performance is in fact the best and optimal use of resources Since the composition of investment is an important determinant of growth rate of the economy, public policy must discourage the flow of resources to low priority areas so that they could be diverted to vital sectors of the economy. By imposing high tax rates on luxuries and other low priority items (such as motor cars, air conditioners, and jeweler), the government can discourage the consumption and production of such items, ensuring in the process release of resources for high priority sectors. Conversely, production of necessities of life and employment-oriented industries can be encouraged by offering tax concessions or even subsidies.
- Distributive Justice. Distributive justice or economic justice is an important function of tax policy. Economic justice relates largely to distribution of tax burden and benefits of public expenditure. It is a component of the broader concept of social justice, which encompasses, besides distributive justice, such questions as treatment of women and children, and racial and religious tolerance in a society. Tax policy is a democratic method to influence the distribution of income and wealth on desired lines. The main ingredients of this policy can be (a) progressive direct taxation of income, wealth, and property transactions, (b) taxation of commodities (customs duty, excise levy, and sales tax) purchased largely by high-income groups, and (c) subsidies (negative taxation) on goods purchased by low-income groups.
- Stabilisation. Initial developmental efforts are generally marked by inflationary tendencies in an economy. Inflation, if uncontrolled, may thwart all development plans and bring misery to the poor. A reasonable degree of price stability should be a primary concern of a government’s economic policies. The overall level of economic activity in an economy depends upon aggregate demand, relative to capacity output. At times, the level of aggregate demand may be insufficient to secure full employment of labor and other factors of production. At other times, aggregate demand may exceed available output at full employment level. Government intervention in both the cases becomes essential to correct such disequilibria in the economy.
The evaluation of our existing tax system with reference to the foregoing objectives is a difficult task because various other policies (like public expenditure policy) may be geared to achieve the same objectives. The Task Force on tax reform, headed by Mr. Shahid Hussain, should have concentrated on these questions rather than just suggesting a few changes here and there. To what extent the redistributive objective has been served and what was the relative role of tax policy in it is a difficult question to answer. Moreover, the various objectives of tax policy may not always work harmoniously. Rather, they are often in conflict with each other if not mutually exclusive. Since the tax system of a country grows out of the interaction between political judgment and economic rationale, the process of compromises and trade offs is influenced by political expediency and economic logic, the former, in most cases, having the upper hand. In fact, political requirements and economic thinking change with time, giving new directions to tax policy. As Richard Bird has observed, “ Tax reform is, therefore, a never-ending process, not something that can be brought about once and for all and then forgotten.”
We must devise a system of taxation, which generates the least loss of welfare. Optimal taxation involves a variety of questions like the ratio between direct and indirect taxes, progressivism of taxes, trade off between equity and efficiency and other related issues. It is unfortunate that these vital areas have not been discussed in the reports prepared by the handpicked tax consultants of the Task Force. It shows the level of their understanding of tax reform. The patchwork here and there is what has been suggested whereas we need a comprehensive shift toward optimal taxation.
Compliance costs refer to costs incurred by taxpayers or third parties in complying with a tax, over and above the tax payment made to public authorities. The third party compliance costs are those incurred by taxpayers in discharging their legal responsibility as tax collectors, e.g. deducting income tax from salaries and passing it on to the tax authorities.
The cost of tax compliance in Pakistan is not only very high but also leads to corrupt practices. The majority of the tax officials are engaged in “practice” and they charge “fee” for their “services”. They ask the taxpayers to pay just a nominal tax, but get enormous amounts from them to either keep them out of tax net or at the lowest ebb of tax slabs. This phenomenon has destroyed our entire tax culture.
The independent professionals are also left with no choice but to join hands with these corrupt “tax practitioners”, who are part of the tax machinery but are engaged in massive tax evasion by inducing the people to pay them and not the State. The people are paying huge amounts, but only fraction of its goes in the national treasury, the rest in the pockets of tax officials and their friends in professions. It is a sad situation. The cost of tax compliance for an ordinary Pakistani is too high. We will have to evolve a system where these middlemen are removed.
Three types of compliance costs mentioned below have to be brought to minimal level to attract people to pay taxes voluntarily and without and hassle:
- Money costs like payment for legal advise, fees to accountants, cost of postage, telephone calls, traveling, books, and litigation.
- Time costs include time taken to consult tax advisers, complete tax returns, and to travel to tax offices.
- Psychic costs are the worries and anxieties associated with tax payment and tax processes.
Cost- Yield Ratio
It is the cost of collection expressed as a proportion of tax revenue. A lower cost-yield ratio is considered indicative of the efficiency of tax administration. Unusually high cost-yield ratio is a drag on the public exchequer. Thus, cost-yield ratios may be used to evaluate administration of competing taxes. The Task Force and its consultants have not undertaken such an exercise.
Presently, the CBR has shifted the collection of taxes to withholding agents. It is an undisputed fact that these withholding agents collect 80% of total taxes and the CBR own efforts yield just around 20% of total collection. It means that CBR has been doing a worthless job. The withholding agents do not get any compensation for their work on behalf of the CBR, rather they get nasty orders u/s 52 of the Income Tax Ordinance, 1979 for even minor lapses. There is no assistance or education for them available from tax departments. It is a pathetic state of affairs, which need to be addressed immediately.
Effects of Taxes
Taxes affect economic behaviour of individuals and organizations in several ways. They affect our decisions regarding savings, investments, location of production centers, techniques of production, and above all consumption of different goods.
All taxes involve money burden on the people. Total yield of a tax to a government indicates total direct money burden on the citizens. Taxes also generate indirect money burden. For example, the government collects excise duty or sales tax from the producer who in turn recovers it from the consumers. There is generally a time gap between the payment of excise or sales tax by the producer/seller and its subsequent recovery from the consumers. The lock up of money during this period devolves on the producer an indirect money burden, which is equal to the interest he could have earned on that money.
Similarly, a distinction is drawn between direct and indirect real burden of a tax. According to Hugh Dalton, “To part with a shilling in payment of a tax means a greater sacrifice of economic welfare for a poor man that for a rich man. But that is a question, not of the incidence, but the direct real burden of the tax. Again, when the price of sugar is raised by taxation, a family may have to eat less sugar, and so make a sacrifice of economic welfare. But that is a question, not of the incidence, but the indirect real burden of the tax.” By distorting consumption patterns, taxes may lead to inefficient use of resources. Taxes also affect the relative economic positions of individual sand households.
In Pakistan a gradual shift from personal taxes to indirect taxes on goods and services (even under the Income tax law) has created a more burden for the poor and less on the rich. It is painful to note that present structure of presumptive taxation has complicated the poverty problem of Pakistan. According to a recent study of Asian Development Bank, the tax system of Pakistan, which was progressive till 1990, was converted into regressive regime in 1991 with the introduction of provisions like section 80B, 80C, 80CC and 80D in the Income Tax Ordinance, 1979 and VAT-type tax in the Sales Tax Act, 1990. The result is that during the ten years’ period (1991-2000), the tax burden on the poorest households is estimated to have increased by 7.4 percent, while it declined by 15.9 percent for the richest households. This study of ADB is eye-opener for the target-oriented CBR’s stalwarts (sic) that in the frenzy of showing higher figures to their foreign masters they have put extra burden of taxes on the poor of Pakistan. History will never forgive them for this senselessness and shamelessness.
There is an urgent need to readjust our tax priorities by giving relief to the poor and taxing the rich and the mighty. At present we are doing the other way around. The present tax structure if continues will destroy our economic growth, hamper efficient use of resources, both physical and human, and will ultimately lead to civil strife as richer are paying no taxes and the poor are overtaxed. It is criminal that the present Task Force on taxes has not even touched this most crucial aspect of our oppressive tax system, not to talk of suggesting any means to rationalize the incidence of taxes.
 Dr. 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: firstname.lastname@example.org; website: http://www.paktax.com.pk). He is a member of the visiting faculty of the Lahore Institute of Tax Education [LITE]. 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.