Huzaima Bukhari & Dr. Ikramul Haq
At present, both the centre and provinces are not collecting taxes according to their respective potential due to weak enforcement and inherent problems of an out-dated tax system. Total tax potential of Pakistan is around Rs. 12 trillion if agricultural income tax and other provincial and local taxes are also collected efficiently. As shown below, at federal level alone, income tax alone can be collected to the tune of Rs. 7 trillion provided the entire undocumented economy is brought into tax net. So far all efforts to achieve this objective have miserably failed. The existing tax system itself is the root cause for encouraging parallel economy, the reform of which is a fallacy. Patchwork here and there is just an exercise in futility and no matter how many tax reform commissions or committees are constituted the consequence would be curing the incurable. Remedy lies in dismantling the existing oppressive tax system and shifting to a flat-rate that is pragmatic, growth-oriented, workable and acceptable to all stake-holders. Under this flat rate taxation, those not coming into tax net or avoiding true disclosures would opt to pay voluntarily as rate is minimal and compliance cost almost nil. Tax system is meant to incentivize growth and not otherwise as the present one is doing.
After levying all kinds of oppressive taxes, the federal government has failed to bridge the ever-increasing fiscal deficit that is creating a greater debt burden—at present 60% of tax revenues are going towards debt servicing alone. On the other hand, provinces are critical of inefficiencies of the Federal Board of Revenue (FBR) due to which their share in the overall divisible pool is insufficient to meet their annual budgetary requirements. Since the share of every province in federal taxes under the National Finance Commission (NFC) is dependent on how efficiently taxes are collected by FBR, it is important that centre and federating units actively participate in the tax collection apparatus/processes/efforts. No serious debate has ever been initiated on the issue as to how we should increase the size of the cake to ensure that both the centre and provinces flourish as sufficient funds are made available to run the governments and fulfill the needs of the people.
Tax System in Perspective
For the last twenty years, we have been ferociously criticizing the tax system of Pakistan pinpointing both legal lacunae as well as enforcement failures. Instead of expecting improvement on the basis of these disclosures, we have observed that matters are getting from bad to worse. Rather than taking serious lessons, the Ministry of Finance is bent upon continuously indulging in the most uncouth forms of experimentation causing not only total unrest among the citizens but also resulting in massive revenue losses. Consequently we have now resolved to cease discussions on the present rotten and fruitless tax system that has created nothing but distress and has violated all norms related to the true philosophy of taxation.
Pakistan’s current pathetic state of documented economy has much to do with the way taxes are being administered for the last three decades—from a tax compliant public to a tax rebellious one, from high tax-to-GDP ratio to an obnoxiously low one, from greater revenue from fewer taxpayers (2 million) to very low revenue from a broad-based population (approximately 20 million), from a relatively thriving economy where debts were at their lowest to an apparent prosperous one where share of debts is 68% of the GDP, from a comparatively greater reliance on direct taxes to a complete turn-around towards indirect ones (even in the garb of income tax law which is essentially a form of direct tax), from relative simplicity of compliance to complicated procedures both at the federal and provincial levels especially in the aftermath of the Eighteenth Constitutional Amendment for which the earlier government takes immense pride. Even the Inland Revenue Service has transferred a major portion of its responsibilities of collecting tax on withholding tax agents leaving very little to justify its own existence.
In short, all that could have been done has been done to make the life of a compliant taxpayer as miserable as possible and snatching from him that little iota of motivation that was egging him on to be an obedient citizen of this country. The helplessness of seeing one’s hard-earned money going down the drain has compelled many to look for greener pastures around the world where their taxes would trickle down in the form of some benefit coming back to them. With this in mind, it becomes imperative at this stage to rethink and devise a scheme that would alleviate the sufferings of the common man and help generate substantial revenue for governments to function comfortably. Our country is rich in resources and its people are very generous. There is no doubt that a logical scheme of things capable of sucking in large revenues without disrupting the common man’s life would be a welcome respite from the constant lashing by tax collectors.
Another important factor that discourages compliance with tax laws is the extremely complicated and cumbersome nature of procedure involved in being registered with the revenue authorities. Even the corporate and educated class finds it difficult to comprehend, follow and observe the simultaneously applicable innumerable legal obligations, what to talk of the illiterate and ordinary man on the street. If a survey is conducted with respect to merely the advance tax provisions (almost 58 in number), it would reveal how a person is supposed to be aware of so many avenues where either tax is being withheld or he is himself paying income tax and the consequences of these taxes, the credit of which he may or may not be allowed to take while filing his return. In the first instance, a highly meticulous record of all such transactions that invoke taxes would have to be maintained and secondly, an even higher level of grasp over the law would be required to apply it. The poor quality of governance and enforcement of law is observable in the way Pakistan’s road traffic is managed where, irrespective of educational background or status in society, every person, whether he is a pedestrian, cyclist, motorist or heavy vehicle driver, is assumed to have complete knowledge of traffic rules. In such a bleak situation, how can the government be justified in imposing regulations that are beyond comprehension?
Considering the present level of inflation and the high cost of living, the minimum threshold of income (Rs. 400,000) where no income tax is to be paid nor a return needs to be filed is within reach of an overwhelming population including people who are earning income from simple employment, trade and vocations. With the prevailing standards of literacy in the country how can it be expected that the common man has any cognizance about tax laws let alone complying and then tackling the authorities who are perpetually ready to whip anyone—innocent or guilty. Had it been restricted to simple arithmetic, things could have improved but the cruel methods adopted to teach the nation lessons in paying taxes have only proved detrimental rather than motivating. People take pride in beating the authorities, no exemplary punishment has been meted out to confirmed evaders, no effort has been made at the grass root levels to educate the public about its obligations and instead of serving the nation, officials of the revenue department are poised to pounce upon the first stray taxpayer to squeeze him dry. Revenue officers are trained to look suspiciously at every registered taxpayer—their motto being “guilty until proven innocent.” Even though law requires that officers should counsel and guide the taxpayer with respect to his duties and rights, he is conveniently forced to engage a tax consultant who, if professionally unethical, is capable of causing much more financial damage to his client than the amount of tax in question.
Black economy and tax losses
Tackling twin menaces of black money and tax evasion has always been a failure in Pakistan. Successive governments, instead of dealing with these issues have been pardoning and appeasing tax evaders through various laws and amnesty schemes. The result is obvious—there is an ever-growing informal economy. The present accumulated size of underground economy is estimated at Rs. 30 trillion; almost equal the size of documented economy. If tax at flat rate of 10% is offered to all who have failed to pay in the past, in just one year FBR will collect Rs. 3 trillion and then in future this figure would be much higher compared to what is collected at present—in fiscal year 2014-15 FBR collected merely Rs. 2.58 trillion against documented GDP of around Rs. 24.7 trillion.
The New Paradigm
Under the afore-stated situation of imbalances, a fresh approach and a renewed policy are urgently needed to replace the entire taxation system for fiscal stabilization. The equation is simple. Federal government needs at least Rs. 7 trillion of revenue (for meeting all development and non-development expenditure along with retirement of expensive loans), for which determination of a fair tax base is imperative. The current complex system, only favours a few thousand officers and their staff along with people having money power and who can blatantly flout the law. It is possible to suggest a simple flat rate tax that is neither burdensome nor difficult to implement but it would deprive the bureaucracy and some vested-interests who would be most likely to oppose it. Nonetheless there is no option but to dismantle the existing, out-dated and anti-growth tax system if we have to overcome the twin but inter-related malaises of fiscal deficit and debt burden.
Arthur B. Laffer and Stephen Moore in their book “Return to Prosperity,” have expanded upon a theory that meets our existing conditions. While elaborating upon the practicality of flat rate of tax, they write:
“Excessive taxation is detrimental to labor and capital, poor and rich, men and women, old and young. Excessive taxation is an equal opportunity tormentor. Businesses locate their plant facilities in order to make higher after tax returns for their owners. In the short run, higher taxes on labor or capital lower after tax earnings. During depressed times, businesses are often desperate to reduce costs because of a shortfall in revenues. Increased taxes in one location can be the final straw leading to businesses’ relocating to more tax friendly locations or making the ultimate decision to close down operations. In the longer run, immobile factors (such as low wage workers and commercial and residential real estate) are left to suffer the tax burden.”
Referring to the significance of mode of taxation, the writers draw justification from a noted nineteenth century American economist Henry George who wrote in his book, “Progress and Poverty” (1879):
“The mode of taxation is, in fact, quite as important as the amount. As a small burden badly placed may distress a horse that could carry with ease a much larger one properly adjusted, so a people may be impoverished and their power of producing wealth destroyed by taxation, which, if levied in any other way, could be borne with ease.”
There has to be a source of motivation for taxpayers to comply voluntarily and to some extent eagerly in contributing towards the national exchequer. Whenever the governments resort to high-handedness in collecting taxes, the people term it as broad daylight robbery, instrumental in encouraging tax evasion. As propounded by the eminent authors of “Return to Prosperity” on pg. 174:
“The theory of incentives provides the basis for the concept of a flat-rate tax, which is so called because a tax applies equally to all sources of income and does not change as a result of taxpayer’s volume of income. Any exemptions, deductions, differential rates, or progressivity would, as a matter of linguistics, preclude the name flat tax. They also represent a deviation from the principles of efficient taxation. Such exemptions to the even application of a single narrow tax base, lead to a higher tax rate, make for greater complexity, and increase tax avoidance.”
They further say that:
“In the realm of economics taxes are negative incentives and government spending entails positive incentives, subject to all the subtleties and intricacies of the general theory of incentives. People attempt to avoid taxed activities—the higher the tax, the greater their attempt to avoid.”
The tax system that will work smoothly for Pakistan, keeping in view our peculiar socio-economic circumstances and mind-set of masses, must be a flat rate with no compliance hassles. All taxes should be merged into one single tax with complete assurance to the masses that they would be free from any kind of harassment; and money collected would be spent towards their welfare. The agenda of fair taxation cannot succeed if wastage of public funds and its abuse by the rulers continue unabated. The quid pro quo for paying taxes is as important as the system to collect tax. Where the public is blamed for not paying their due share, public authorities are equally, if not more, responsible for indulging in corrupt means taking cover of complicated procedures that eventually lead to poor collection of revenue. As mentioned by the writers:
“A flat rate eliminates much of the inefficiency in a convoluted tax system by broadening the tax base and sharply reducing marginal tax rates. Many of the distortions that exist with the current tax system are minimized. A flat tax rate reduces the collection cost per dollar of tax revenue and eliminates much of the bureaucracy necessary to monitor and enforce numerous taxes. Its adoption leads to a surge in growth and creates a more competitive economy.”
The tax base with respect to direct tax vis-à-vis fair distribution of incidence can be achieved in the following two ways:
- 2.5% tax on net worth exceeding Rs. 10 million on the closing date (previously known as ‘valuation date’ under the repealed Wealth Tax Act, 1963); and
- 10% flat rate tax on net income.
[Note: Wealth tax paid would be deductible from the income tax liability to mitigate extra burden as was the case when both income tax law and wealth tax law were in operation].
This kind of simple taxation would induce voluntary compliance provided all the citizens are aware of the fact that competent and effective tax machinery exists having a tax intelligence system that can easily detect tax avoidance. Without this deterrence even the new system which is a great deal simpler, will be unworkable. Nowhere in the world is proper collection of taxes possible without a strong enforcement apparatus. However, the apparatus should be friendly and firm—friendly, to the extent of educating and guiding the people for fulfillment of their tax obligations, and firm to the extent of punishing willful defaulters.
As far as sales tax is concerned, it has been emphasized time and again by us that Pakistan needs harmonized sales tax (HST) which should be single-stage and single-digit. This envisages collection through a National Tax Authority which should replace all existing authorities at both federal and provincial levels.
The National Tax Authority (NTA)
National and provincial assemblies should pass a law agreeing on establishment of NTA responsible for collecting all taxes imposed by the federal and provincial governments. This would facilitate people to deal with a single revenue authority rather than multiple agencies at national, provincial and local levels. The mode and working of NTA can be discussed and finalised under Council of Common Interest [Article 153] and its control can be placed under National Economic Council [Article 156].
The provinces should also feel responsible for better and efficient tax collection. Presently they are isolated and rely on distribution from the divisible pool whereas the Federal Board of Revenue annually collects less than the assigned revenue target. The responsibility to collect revenues should be joint and several giving a participative sense to all federating units.
The NTA should consist of officers and staff representing the federation of Pakistan as in taxes, both the centre and provinces have equal stakes. If the size of the pie grows every federating unit will get more and the Centre will also have more money at its disposal. For NTA, an all Pakistan Tax Service should be established. Recruitment for All Pakistan Tax Service must be independent of the present Central Superior Services structure. Competent people having knowledge in accounting, law, IT and administration should be selected through a special Board, comprising members from the existing Federal and Provincial Public Service Commissions.
Determination of Direct Tax/Income-Based Method
According to available data, total number of persons having taxable income of more than Rs. 400,000 is between 10 to 12 million and tax base is around Rs. 50 trillion (after taking into account informal economy). Flat rate taxation of just 10% with strong enforcement system will yield Rs. 5 trillion under income tax alone.
Determination of Direct Tax/Wealth-Based Taxation
According to Credit Suisse, total wealth in Pakistan amounted to $495 billion in 2015. This was $170 billion in 2000 showing that total wealth in Pakistan has increased at an annualized rate of 7.4% during the last 15 years—it confirms how untaxed wealth has been growing and what the real size of undocumented economy is. Study of Credit Suisse says that the share of middle-class adults in Pakistan’s total adult population of 111 million is 5.7% (6,327,000 adults). To qualify to be a middle class Pakistani adult, the person must have wealth of at least $14,413. This means that each adult belonging to this class should possess a minimum wealth of Rs. 1,527,000 as per present dollar-rupee parity. If the State levies just 2.5% tax on net wealth of the rich, the total collection will be nearly Rs. 2 trillion.
The incidence of this levy will not be on the less-advantageous segments of society. There would be fewer people—ultra rich and the affluent—to deal with as well as no income computation and no hassles to engage expensive accountants and consultants. Since cost of compliance would be negligible, the affluent would hopefully pay this tax willingly.
Pakistan has the 18th largest “middle class” in the world
Pakistan’s middle class consists of over 6.27 million people, according to Credit Suisse, a global financial services company. In its Global Wealth Report 2015 released on Oct 13, Credit Suisse said Pakistan has the 18th largest middle class worldwide. The study has revealed that 14% of world adults constituted the middle class in 2015 and held 32% of world wealth. The share of middle-class adults in Pakistan’s total adult population of 111 million was 5.7% in 2015 as opposed to India’s 3% and Australia’s 66% in 2015. Middle-class Pakistani adults constituted 0.9% of the worldwide middle-class population. The highest concentration of middle-class population in 2015 was in China (108.7 million), followed by the United States (91.8 million) and Japan (62 million).
Defining ‘middle class’
Economists use a variety of methods, such as income and standard of living, to define what constitutes the middle class. Credit Suisse uses the measure of ‘personal wealth’ – or a ‘wealth band’ instead of an ‘income range’ – to determine the size and wealth of the middle class around the world.
Taking the United States as the benchmark country, Credit Suisse considers an adult to be part of the middle class if they have wealth between $50,000 and $500,000 valued at mid-2015 prices.
Credit Suisse came up with the minimum and maximum figures for the US middle-class wealth band based on its median earnings and the amount of capital a person close to retirement age needs to purchase an annuity paying the median wage for the remainder of their life.
To be a member of the middle class in 2015, according to Credit Suisse, a Pakistani adult must have wealth of at least $14,413.
Determination of the Indirect Tax Base
All existing indirect taxes should be replaced both at the federal and provincial levels with Harmonized Sales Tax (HST). There are multiple tax collection authorities now, rendering the life of the ordinary citizen miserable since he is unable to comprehend complex laws without having to pay heavily to professionals.
If the present indirect taxation is replaced with HST as in a comparable federation like Canada, it would not only improve revenue collection but would also help to alleviate the sufferings of taxpayers who have suddenly been bombarded by multiple tax authorities.
In the Pakistani milieu if a single-stage 5% HST is levied, it would yield at least Rs. 3 trillion both at federal and provincial levels. A comprehensive study, courtesy Tax Reform Commission (TRC), is already with FBR. In this study, prepared by a sub-committee of TRC, even the matter with respect to cascading of prices has been addressed and dealt with satisfactorily.
All taxpayers would happily pay 5% HST as there would be no:
- input/output tax adjustments;
- withholding at the time of receiving payments;
- issues of unpaid refunds; and
- long and tedious audit procedures.
- If we want optimum collection of taxes fairly and without hampering growth, it is imperative to abolish the present tax laws and enact new ones.
- Collection of taxes through a single national authority as suggested above.
- Establishment of a Tax Intelligence System sending quarterly information to potential taxpayers about their economic activities so that they can be informed in advance as to how their incomes and expenditure should finally look like in their tax declarations.
- Prudent spending of public money through a transparent process enjoying the confidence of the people.
The writers, lawyers and partners in Huzaima, Ikram & Ijaz, are Adjunct Faculty at Lahore University of Management Sciences)