Tax Policy and Administration Reform

By

Tax Policy Sub Group

Economic Advisory Council

Members:

Dr. Ijaz Nabi, Chairman

Dr. Farrukh Iqbal

                Dr. Asad Zaman

Dr. Naved Hamid

                Mr. Sakib Sherani

                Dr. Hanid Mukhtar

Tax policy and administration reform

1.    Introduction

1.1       Edmund Burke in his most famous work, Reflections on the Revolution in France (1790) observed that,”The revenue of the state is the state. In effect all depends upon it, whether for support or for reformation. . . . Through the revenue alone the body politic can act in its true genius and character, and therefore it will display just as much of its collective virtue, and as much of that virtue which may characterize those who move it, and are, as it were, its life and guiding principle, as it is possessed of a just revenue.”[1]Federal Board of Revenue (FBR) being the premier revenue collecting authority is responsible for administration of fiscal laws. It is a matter of grave concern that over the past few decades it has not been able to come up to the desired level of revenue generation and performed at a level lower than what was expected. This has resulted in unsustainable fiscal deficits, ballooning public debt and poor economic growth. In a linear comparison with other developing countries the revenue generation performance of Pakistan is depressingly low. As a consequence, there exists a pressing need to introduce substantial reforms that could help in revamping the tax structure and improve the overall performance of the organization.

1.2       The primary drivers for reforms in any taxation agency are almost invariably factors such as fiscal deficit, noncompliance of taxes by the public and problems with government machinery mandated with collection of revenue. These issues force the governments to make possible shifts and changes in the mechanisms of providing the service and administrative and organizational fabric. Tax reforms undertaken to date, have not been all-encompassing and have mainly been focused on adhoc measures and temporary fixes. Several Tax reform commissions and deliberative committees have been constituted for introducing and implementing tax reforms, but have proven to be unsuccessful as a holistic view of the economic realities and organizational shortcomings was not taken.The tax system is cumbersome and the cost of compliance high. It is not simple, pragmatic, growth-oriented, and broad-based. Unless the tax system is made simple and predictable and the cost of compliance substantially reduced the persons outside the tax net cannot be induced to pay their taxes voluntarily. The taxpayers also need to have the confidence that the taxes collected from them are expended judiciously and in a transparent manner.

1.3       Low revenue mobilization in Pakistan stems from a narrow tax base, low compliance and a significant number of exemptions and incentives, which led to a high level of tax expenditure as compared to tax revenue. The tax policy has over the years become hostage to distortive ad hoc measures such as special procedures and regimes for individual sectors introduced to compensate for lack of administrative capacity and political will.On the other hand, tax policy is taken as the handiest tool available to support the economic and industrial policy. While both the uses of tax policy, namely, to help overcome the weaknesses of tax administration and to support the industrial and economic policy are legitimate, what ends up happening in practice is that the issues in both these areas are not confronted directly letting them foster and worsen and the tax policy loses its focus.

1.4       In the last few decades the tax to GDP ratio in Pakistan has remained low not only as compared to developed countries but also as compared to many developing countries in the same region and having similar circumstances. The reasons of this low tax to GDP ratio which is somehow static and immobile in between 12 to 13% are political and structural. There has been not only lack of confidence in government but also a combination of limited effort, convoluted tax structures, and weak enforcement.

1.5       The taxation system of Pakistan suffers from severe administrative and organizational malaise and criticized for a heavy reliance on indirect or withholding taxes leading to an overall regressive generation of revenue that is said to be responsible for disproportionate increase in the tax burden for common masses, promoting incompetence, lopsided distribution of resources, excessive reliance on taxes collected on international trade in the form of import duties, sales tax and withholding taxes on import that are retarding cross border trade and inhibiting efficiencies. The tax base is narrow because of distortive exemptions, subsidies and unbridled tax evasion and lastly the organizational workforce is inefficient and demotivated due to unbalanced work distribution, use of obsolete business processes, lack of professionalism, arbitrariness and above all the general perception about the taxation system being rife with corruption, managed by incompetent workforce with unbridled discretionary powers used for personal gains. The tax mangers are not equipped with requisite professional skills to cope with the changing trends in the economy, they also plagued with lack of motivation complimented with lack of any comprehensive accountability mechanism.

1.6       As compared to the developed countries the taxation department of Pakistan lacks the much-needed professional competence and trained workforce and under such circumstances it is extremely difficult for the government to enact any prospective and robust tax base. There aren’t any integrated procedures for filing of tax returns, documentation of economy, data storage and automated processes and above all there is a lack of confidence between the tax payer and the tax collector. This lack of confidence has emerged out of complaints of harassment of the taxpayers in general and the absence of a robust tax culture. There exists a dire need to improve the relationship between the public and the tax collecting authorities.

1.7       One of the major weaknesses of the tax system in Pakistan is the abysmally low number of persons complying with their tax obligations as less than one percent of the population is filing their tax returns. It is logical to expect that any meaningful tax reforms should aim at bringing the potential taxpayers into the tax net. There isn’t any instance in the world where we can find a well-organized and disciplined group that openly support and agitate for tax reforms process especially enhancing the penetration of the tax net. Only a far sighted and dedicated leadership have the potential and skills to take such bold and innovative steps of revamping the system and challenging the status quo approach. For that leader or statesman, the only consideration will be the success of those reforms in the shape of reducing fiscal deficit and generating more revenue, the aim would be to minimize public debt and control inflation. This is especially true in the case of Pakistan which has hitherto lacked political leadership with sufficient vision to undertake reforms having the potential of antagonizing powerful lobbies thriving on an inefficient tax system. Any attempt to reform an inequitable tax system is likely to be resisted and resented by the beneficiaries of the system.

2.    The need for tax reform:

2.1             The Revenue Need:

2.1.1                In term of number of employees, Pakistan does not have a huge government. However, the footprint of the government on the economy and society is sizeable. Relatively modest size of the government along with substantial functions assigned to the government is an important factor behind low inefficiency and rising corruption in the government.

2.1.2                There is need to increase efficiency of public spending by cutting back on low priority expenditure and reducing waste. Moreover, in the short-run there is also a need to exercise utmost austerity to bring the fiscal house in order. In the medium-run, however, government’s expenditure needs are going to increase due to: (a) large debt overhang; (b) the need to enhance efficiency; and (c) to fill public services and infrastructure gaps.

2.1.3                Government non-tax revenue is declining as a percent of GDP as external sources (notably grants from CSF) of non-tax revenue are drying out fast. Non-tax revenuewhich averaged 4.4% as share of GDP from FY2008 to FY2010, averaged 3.1% from FY2016 to FY 2018.[2]Additional tax revenue needs to be raised to fill the gap left by this drop in non-tax revenue. This implies that tax policy (along with improvement in tax administration) should be productive enough to generate sufficient revenue to meet government’s expenditure needs.

2.2             The Economic Need:

2.2.1                Growth of economy is constrained, among other things, by a distortionary and unfair tax system. Such a system leads to sub-optimal business and investment decisions.Tax system imposes significant pecuniary and non-pecuniary costs on economic activity (beyond the tax revenue). This adds inefficiencies in the economy

2.2.2                Although the prime purpose of tax policy is to raise adequate revenue and not to change behavior, it does affect the behavior of taxpayers. Past tax policies have created a large number of distortions in the economy which not only adversely affect revenue collection but by also forces sub-optimal business and investment decisions. (A good example is the impact on the tradable/non-tradable investment decisions). As such, future tax policy should also focus on reducing tax distortions and improve neutrality and fairness of tax system so as to reduce these constraints and improve economic efficiency.

3.    Approach of the Sub-Committee

3.1       An extensive review of the entire taxation system and tax policy is a momentous task and is not possible in the short period of time allowed to the sub-committee. Such a review would entail an in-depth study of all aspects of tax administration, tax policy and its interaction with boarder economy and economic policy of the government. The tax policy also goes through the annual overhaul during the budget process when more immediate changes to tax policy are made for the short to mid-term. It is expected that the sub-committee will be able to provide its input into that process as well.

3.2       In this report the sub-committee will focus on some of the key structural issues that have held back the country from achieving its full potential. The existence of many of these issues is well known. In fact, in any commentary on the abysmal situation of revenue collection in Pakistan, these issues will be prominently mentioned. But the discussion of these issues does not go beyond scratching the surface and solutions offered are either too idealistic that ignore the realities of implementation or do not go beyond tinkering on the margin.

3.3       In the following section the key issues aregrouped thematically and discussed in detail.

4.    Conceptual issues in tax design

4.1             Tax design and objectives of tax policy:

4.1.1    ‘For too long, … tax reforms have been approached ad hoc, without regard to their effects on the evolution of the tax structure as a whole. As a result, many parts of our system seem to lack a rational base. Conflicting objectives are pursued at random; and even particular objectives are pursued in contradictory ways’. (Introduction to The Meade Report – IFS). The same is true of Pakistan. There is a need for clear principles and objectives of the design of Pakistan’s tax system. What should a “reformed” or restructured tax system strive for? 

4.1.2    A tax system and efforts to reform it strives for equity, neutrality, vertical and horizontal fairness, adequacy of revenue, efficiency, simple revenue collection, simplicity, stability, reducing multiplicity, documentation of the informal economy, encouragement of economic growth and private investment, or a combination thereof. All reform efforts and policy proposals quote one or more of these as justification for various measures.

4.1.3    However these principles are not always perfectly aligned. As in all policy decisions there are trade-offs involved. The principles of simplicity of procedures may conflict with documentation requirements. The Presumptive taxation of certain sources of incomes such as commercial imports, exports and contracts, which are taxed on the basis of gross value of transaction, are often subject of criticism on the grounds of lacking progressivity, changing the character of tax from direct to indirect and being distortionary. However, there is seldom any objection to this procedure from taxpayers subjected to it since they find it simple, convenient and less open to discretionary actions by tax administration. The desire for tax neutrality clashes with using tax policy for promoting targeted economic growth and investment. Desire for simple broad based tax clashes not only with desire to exempt necessities from taxation but also requires a much more extensive field enforcement mechanism.

4.1.4    The absence of a comprehensive evaluation criteria that would account for the trade-offs involved and provide guidance in resolving these conflicts and prioritization results in a policy formulation process where a relevant label out of a menu of desired objective is slapped on a policy proposal that has been arrived at independently without analysis of the trade-offs involved.

4.2             Loss of Focus of Tax policy vis-à-vis Economic Policy

 

4.2.1    The tax policy is an important tool for economic planning of the country. It has to be responsive to needs of the economy and promote economic activity. Revenue target fixation and legislative work should be based on the condition of the economy and potential risks and opportunities it faces. In this regard policy should be based on analysis and research work about the economy, estimating the revenue potential of different sectors, which sectors need protection etc. FBR should develop its capacity for statistical, forecasting as well as qualitative analysis in order to rationalize its revenue target fixation and prospective legislation or policy initiative. Similar strengthening of the capacity for economic development is also required.

4.2.2    Instead of such rigorous, analysis based policy formulation, often the tax policy is used to hide costs of economic policy. This has resulted in a plethora of tax exemptions the economic rationale of which, let alone the cost, has seldom been analyzed or reviewed. It is generally the first instinct for any industrial policy design to incentivize through exemption from all taxes. This tax exemption or tax expenditure has the advantage that it is not budgeted and so the cost in terms of lost revenue is hidden.

4.2.3    Too Low Tax Rates is another area where theinterest of revenue have been made subservient to short term political gains or being unable to find resources for increasingsalaries. Pakistani personal income tax rates are too low. A person earning Rs. 2.4 million a year pays 60,000 in Pakistan, 532,500 in India, and 397,500 in Bangladesh. A Pakistani taxpayer earning Rs. 400,000-1200,000 a year pays a fixed tax of Rs. 1000-2000. Such low tax rates are not optimal (cannot even cover the administrative and compliance costs). Research shows that the elasticity of taxable income in Pakistan is reasonably small. Tax rates therefore need to go up in small increments instead of going down.

4.2.3    Yet another form of distortionary practice is granting exemptions to state owned enterprises. The economic justification for state owned enterprises is to fill the gap where private enterprises does not want to operate for any reason and they are often made exempt for financial viability. However, once established for such reason, many of the enterprises start competing with private businesses even in areas where the later is willing to work but cannot compete with a tax exempt entity. Thus they prevent development of expertise in private sector, crowd out opportunitiesfor private business, incur hidden cost to the government through tax expenditureand prevent healthy competition that would promote efficiencies.

4.3             Loss of Focus of Tax policyvis-a-vis Tax Administration

 

 

4.3.1    The tax administration is not immune to general erosion of writ and administrative capacity of the state in Pakistan. In fact, the loss of capacity, which was not adequate even to begin with, is more pronounced because there is no constituency working in favour of strengthening it apart from general need for higher revenues. Since the strengthening of tax administration is not desirable for many powerful stakeholders, the weakness is rarely tackled head-on through most efficient and least distorting solutions. Instead the easier route of trying to fix administrative weakness through policy measures is resorted to where real costs are hidden.

4.3.2    The result is that tax policy has over the years become hostage to distortive ad hoc measures such as special procedures and regimes for individual sectors introduced to compensate for lack of administrative capacity and political will. Tax policy making in Pakistan has been driven by the desire to compensate for enforcement failures, structural leakages and lack of resources to broaden the tax base. But the administrative weakness always remains there since there was no effort to address it while the ad hoc policy measures make tax laws a morass.

4.3.3    The first and foremost structural change in policy sphere is to realistically divest it from the daily grind of collection without losing the basic relationship between the two. It is important that tax policy should be informed by and designed to respond to the realities of implementation within the complexities of the society and economy. But no matter how well done, the policy measures will never solve the problems of administrative weakness. Strengthening of the tax administration at all levels is the most important task.

5.    Issues related tofederalism and fragmentation of taxes

5.1  Fragmentation of Tax System:

5.1.1                Like any other federal system, tax administration is organized almost independently at federal and provincial (and local) levels. There is a lack of coordination and sharing of tax-related information across levels of government, which poses issues. Moreover, tax system at the provincial level is further bifurcated on the basis of taxes to be collected, with Excise and Taxation Department responsible for collecting all urban taxes, except sales tax on services; Board of Revenue is entrusted with collection of agriculture land-based taxes; provincial revenue boards/authorities are created to collect only the Sales Tax on Services. The coordination among the three revenue bodies within a province too is deficient.

The issues of fragmentation of Sales Tax and Income Tax are discussed in more detail in following sections.

5.2  Fragmentation of Sales Tax between Federation and States:

 

5.2.1.   The most important issue in Sales Tax is the taxation of goods and services by the  Federation and the Provinces respectively. This is a constitutional issue which has huge political ramifications. but it needs to be discussed because it has a direct impact on taxation.. The collection of sales tax on services by provinces has given rise to divergent views of the provinces on the mode of sales tax collection on services which have in turn lead to serious disputes. The federating units differ over the mode of collection of sales tax on services: whether it should be on the basis of ‘origination’ or ‘destination’. The taxpayer,meanwhile, is compelled by each tax authority to follow its interpretation, that frequently is in conflict with another tax authority’s interpretation. The dispute manifestsitself in terms offederating units attempting to grablarger shares of the pie and not increasing its total size. In fact, this uncertainty in taxation has,for the momentprevented the problem of  a race to bottom. In this scenario, the various tax jurisdictions try to increase their revenue by attracting taxpayers to their jurisdiction by offering lower and lower tax rates and exemptions instead of better economic infrastructure. .

5.2.2    Apart from disputes of legal interpretation, there is also the issue of significant costs of dealing with and reporting to multiple tax authorities. In the Doing Business 2018 report of the World Bank, the rank of Pakistan in difficulty in paying taxes is 172 as compared to overall rank of 147. The reports provides country ranking in 10 different categories. The rank of 172 in the category Paying Taxes is worst rank of Pakistan in all of the 10 categories pulling the overall ranking down.. According to the report,  a major cause for this poor rank isthe long duration of time consumed in paying taxes in Pakistan which comes to 311.5 hours annually.Of these 311.5 hours, time consumed by payment of “Goods and Sales Tax (VAT)” has been reported at 231.5 hours.. Compared to this, payment of the “Corporate Income Tax” takes 40 hours annually.[3]The reason that paying Sales tax is so time-consuming and cumbersome is that it requires reporting similarinformation to central and all provincial tax authorities and getting audited by multiple sales tax authorities. 5.2.3       Interestingly the Indian VAT worked in the opposite manner. That is to say in India it’s the federating units that tax supply of goods whereas the center taxed services. In this manner the issue of origination and destination in the case of tax on services was mitigated. However the same issue did arise in VAT on goods across state lines. Consequently India has reformed it taxation system and introduced a reformed GST levied charged and collected by the center. The tax so collected by the Union in a particular state is then divided between the center and that state as per a predetermined ratio.

5.2.4    Pakistan on the other hand was taxing both goods and services at the Federal level for long time but ultimately provinces were given the power to tax services. The biggest reform that may be required to improve collection and increase the ease of collection is to follow India’s example.[Office1] 

5.2.5      Prior to 18th Amendment, the Sales Tax on services was still the jurisdiction of provinces but the tax was collected by center on behalf of provinces. After the 18th amendment the provinces started collection of Sales Tax on services themselves. However, it was incidental and not result of any change in constitution.

5.3  Taxing Income from Agriculture:

5.3.1    Agriculture is a major part of Pakistan’s economy. According to our system of fiscal federalism, the taxation of agriculture income is a provincial subject. The Economic Survey of Pakistan 2017-18 estimates the share of agriculture in GDP at 19.2%. This is not commensurate with the Income Tax collection from agriculture. The Income Tax collected by Federal Government was around 4.56% of GDP in 2016-17. On the other hand, the entire revenue collection by the provinces was about 1% of GDP of which agriculture income tax was a very small part. According to Punjab Government Budget for 2017-18, the Agriculture Income Tax collection for 2016-17 was estimated at Rs. 1.2 bn which comes to 0.7% of total revenue collection of Rs. 175.2 bn by the Punjab province. This shows the gap between the potential and collection of the agriculture income tax.

5.3.2    However, there is further complication of what falls under agriculture for income tax collection by the provinces. In view of the definition of ‘Agricultural Income’ available in Article 260 of the constitution and Section 41 of the income tax ordinance 2001, the agriculture income that falls in the purview of taxation by the provinces is mostly the crop based income. The Economic Survey of Pakistan 2017-18 breaks-up the agriculture sector in to the components given in Table 1 below:

Table 1: Share of Agriculture in GDP 2016-17

	Share of GDP in 2016-17
Total Agriculture: 1. Crops a) Important Crops b) Other Crops c) Cotton Ginning 2. Livestock 3. Forestry 4. Fishing	19.22 7.09 4.55 2.09 0.46 11.33 0.39 0.41

                                                                        Source: Economic Survey of Pakistan 2017-18, Statistical Appendix, Table 1.2

5.3.3    Of these, only Crops at S No. 1 in Table, which is 7.09% and maybe 0.39% from forestry, should be subject to Provincial Income Tax on agriculture. However, due to difficulties with the common understanding of this arrangement and the practical problems in many cases of separating the income from these different sources as well as the institutional inertia due to historical reasons, most of the income under all these sub-sectors of the agriculture escapes taxation.

5.4  Issues of fiscal federalism:

5.4.1                The Seventh NFC Award increased the share of provinces in the pool of federally collected taxes from 46.25 percent to 57.5 percent. Irrespective of its fiscal and service delivery rationale, this move has created strong disincentive for both the federal and provincial governments to raise additional revenue. For the federal government the cost of not collecting taxes is disproportionately shared with provinces, thereby diluting efforts in that direction. Provinces on the other hand get free money from the federal divisible pool, making it easier for them to avoid political cost of imposing additional (or even collecting the existing) taxes. Moreover, these shares were enshrined in the Constitution through the 18th Constitutional Amendment as the minimum share for the provinces in all future revenue-sharing arrangements. Making it next to impossible for future NFCs to adjust the shares even if they strongly feel that mistake was made in determining these shares in the 7th NFC Award.

6.    Issues related to major tax evasion

6.1  Real Estate Sector:

6.1.1    Real Estate is a major destination for investment in Pakistan. According to Table 1.2 of Statistical Annex to Economic Survey of Pakistan 2017-18, in 2016-17, Housing Services (Ownership of Dwellings) comprised 6.6% of GDP. The cultural importance of home ownership and lack of options considered safe for investment of savings, real estate is a major destination of investment in Pakistan for people across a range of resources and its role in economy looms large.

6.1.2    Real Estate sector is also important since being a destination of investment the record of ownership of which is meticulously maintained by the government, it is also the point where a large part of income from informal economy and untaxed black money becomes visible to the government. Over time, the tax authorities have taken many steps to use the real estate transactions as tool to identify instances of tax evasion and bring people in to tax net. Such measures range from collecting information from property registration authorities and imposing withholding taxes on the buyers and sellers of immovable property to identify tax evaders, separate rate of withholding tax for non-filers and imposing restriction on the purchase of immovable property by the non-filers with few exceptions.

6.1.3    Therefore there is a strong incentive to under declare the value of immovable property. This tendency to under report the value is older that the Income Tax considerations and rooted in avoiding the transaction taxes on the registration of the immovable property but the effort to hide income might be even bigger consideration now.

6.1.4    Often, in the cases of both investors and people buying property for personal use, immovable property is often bought from the proceeds of sale of some other property. However, since the sale proceeds are under reported, the cost of buying the property from such source is also under reported. Since immovable property is the biggest asset most people own, any chain of investment transactions that involves purchase or sale of immovable property by any party is forced to be under reported. The under valuing of sale of immovable property transaction is a major source of under reporting of a number of other transaction in the economy and in turn under declaration of income.

6.1.5    Since over time rates of various taxes collected by provincial governments, cantonment boards, withholding taxes etc on purchase and sales of immovable property have been fixed in view of undervalued prices, it is very hard to break this low price equilibrium by any one stakeholder and a holistic approach is required.

6.2  Under-invoicing and underreportingof Imports:

6.2.1    A phenomenon that is well-known as a way of tax evasion and source of corruption but whose pernicious effects on broader economy and taxation structure are often not well understood is under invoicing andundervaluation of imports. The damage done by under invoicing or mis-characterizing of the imports is not limited to immediate loss of revenue at the import stage. In fact, having once entered the country at under invoiced value, the imported good forces the entire chain of entities that come in contact with it to misreport the values of their costs, sales and all manner of other accounting figures in order to cover for that under invoiced import.

6.2.2    Thus in many sectors, the accounting in entire sector is working on a low value equilibrium just because a key import is under invoiced. Even those businesses that do not wish to participate in this under reporting have to remain complicit because of the tax incidence on them elsewhere if they try to report rest of their business transactions accurately.

6.2.3    Not only customs tariffs, but sales tax and income tax on imports are also collected at the import stage – the incentive to under invoice or mischaracterize is particularly strong and results in tax loss in multiple taxes and false accounting at multiple stages. If an imported key input is purchased at under invoiced price, the output has to be under invoiced as well to keep profits or sales tax on sales from ballooning. Thus the entire chain of taxation in different taxes is distorted with no easy option for the taxpayer to get out of this vicious circle of under invoicing keeping the entire sectors of the economy trapped in this low value equilibrium. While the smuggled goods mostly affect the informal sectors of the economy the damage caused by the under-invoiced imports spreads throughout the economy.

6.2.4    A related and equally significant problem that also cuts across customs and sales tax is that a lot of the imported inputs “disappear” either into the informal sector or as inputs to sales-tax liable firms whose outputs are then underreported. This can be tackled given the degree of automation of customs and sales tax.

6.3  Smuggling:

6.3.1    In the context of international trade, the tax policy has to also cater to the phenomenon of smuggling which deprives the state not only of import revenues but also its due share of domestic taxes which accrue from utilizing such illegally acquired inputs/products in the domestic sector. It is, therefore, of extreme importance that the new tax policy addresses this critical issue by adoption of tangible measures that enable the state to extinguish or at least minimize the damaging impact on the national economy. While the magnitude of smuggling remains empirically unexplored, it is a fact that it poses a serious challenge to the exchequer. Therefore, in order to maximize revenues, the government may adopt a Unified Approach that incorporates the core values of trade facilitation, drawing extensively upon principles of risk-mitigation and effective enforcement. The overall impact would be to gradually and significantly impact the “trade” through informal channels, which in turn would increase legitimate imports and ultimately be instrumental in maximizing revenues.

7.    Discussion on some structural issues

In this section certain structural issues, which are ubiquitous in any discussion of tax policy in Pakistan, are discussed to have a deeper understanding of all aspects of these issues.

7.1              Withholding Taxes

7.1.1    Pakistan’s taxation system is criticized for its undue reliance on indirect taxes and a wide range of withholding taxes. The increase in income tax collection in the past has been attributed as being due to over 60 types of withholding taxes both adjustable and non-adjustable. The withholding taxes are castigated as being regressive and putting undue burden on the common man and sparing the rich. The criticism has never been subjected to a stern analysis and always accepted as a truism.

7.1.2    Withholding taxes are neither unprecedented in the world nor introduced in Pakistan in recent times only. All over the world certain income streams such as salary, dividend, royalties, interest, payments to non-residents etc are subjected to withholding taxes which in some cases are treated as final taxes and in others as adjustable against the final tax liability payable at the time of filing of returns. However, in Pakistan the scope of withholding taxes has not remained confined to income streams but has also been extended to cover even items of expenditure. This has led to the criticism referred above. Due to absence of documentation of economic transactions or the lack of their visibility to the tax administration FBR has always been unable to assess actual income when it is earned and has always created legal fictions to treat significant investments and expenses as income since investment and expenditure are a function of the income. In an opaque economic environment, the tax machinery is not in a position to collect due taxes on income so the only alternative is to use proxies and at the same time attempt to make the significant transactions visible to it. The proliferation of withholding taxes in recent past has been the consequence of this approach.

7.1.3    In order to evaluate the claims regarding regressivity of the withholding taxes it would be useful to list the transactions on which these are collected. Adjustable withholding taxes are payable mainly on sale and purchase of real estate above a certain monetary threshold, on domestic electricity bills above Rs 75,000 per month, on education expenses of children in expensive schools in Pakistan and abroad, purchase of international tickets for travel other than in economy class, domestic air travel, on commercial and industrial electricity connections, on booking and registration of motor vehicles, purchase of property in auction, on functions and gatherings held in hotels, marquees etc., persons remitting money abroad through credit or debit cards. None of the above withholding taxes is going to have an impact on the proverbial masses but are a source of documentation of significant economic transactions by persons who should be in the tax net and filing their tax returns claiming the withheld amount of tax as adjustable against their actual tax liability. Yet another group of withholding taxes is collected directly on purely commercial income generating activities such as on Brokerage or commission received, Stock exchange transactions by their members, from CNG stations and petrol pumps, steel melters, cable operators, sales to distributors/ dealers/ wholesalers by manufacturers, sales to retailers by distributors/ dealers/ wholesalers, from commission agents/arhtiis by the market committees, on lease of machinery and equipment, on extraction of minerals, on payments for technical services, royalties and digital services to non-residents  and on purchase of tobacco for cigarette manufacturing. These newer adjustable withholding taxes are in addition to the withholding taxes that have been in vogue for decades including withholding taxes on salary, dividend, imports, exports, contracts, rental income etc.

7.1.4    The incidence of the withholding taxes listed above as already mentioned is largely restricted to persons who otherwise should be paying income tax and the fact that these newer withholding taxes are adjustable and not treated as final tax, addresses concerns regarding fairness and equity. The critics also ignore the fact that these withholdings provide a source of documentation of the transactions having significant economic worth and can not only help in identifying potential taxpayers but if backed by robust data analytic tools can also help in checking under-declaration by existing tax-filers. This wide range of withholding taxes has enabled the tax policy makers to create the distinction between filers and non-filers whereby the non-filers are subjected to higher rates of withholding taxes thus creating an incentive for joining the tax net. Even if a person still opts to remain out of the tax net and forego the tax withheld the system in the short term at least ensures some contribution from such delinquent persons.

7.1.5    However, it has to be admitted that there are certain withholding taxes that are imposed on persons who are otherwise not liable to payment of income tax and return filing. The most notorious amongst these and the one that is widely cited to discredit the entire spectrum of withholding taxes is the withholding tax on mobile phone subscribers. At the very outset it has to be pointed out that this is not a new withholding tax and was introduced in 1996 under the Repealed Income Tax Ordinance of 1979 when the mobile phones and their usage were quite expensive and restricted to upper income groups. However, this became a source of revenue for the government and even when the mobile phone penetration increased exponentially and the masses started subscribing to this service, suitable adjustments were not made to address the equity and fairness concerns. Although the tax is adjustable a vast section of mobile phone subscribers are not liable to file their returns and cannot claim credit of the withheld tax. That was precisely the reason the Apex court stepped in and suspended collection of withholding taxes and other levies from mobile phone users. The withholding tax collected by Banks from profit on debt or markup paid the account holders is another tax that can be termed as unjust in its present shape. This is due to the fact that there is no minimum threshold after which it becomes deductible. Even small accountholders receiving petty amounts are subjected to withholding and the withheld amount is also treated as the final tax on the profit received in the in the case of individuals.

7.1.6    However, the isolated instances quoted above cannot be used to deprecate the entire withholding regime in view of the purpose itserves in the context of the present stage of economy and the capability of the tax administration.[Office2]  However, the policy of treating some withholding taxes on transactions such as exports, imports, contracts and supplies of goods as final taxes adopted in the 1990s needs to be reviewed. This policy was introduced to protect revenues as an admission of weaknesses of tax administration and needs to be reviewed as it creates distortions and discourages documentation. In the Budget for 2018 this process was initiated in a phased manner by changing the regime for commercial importers.

7.2  INDIRECT TAXATION

7.2.1    Pakistan’s taxation system is also criticized for its dependence on indirect taxation for revenue generation. Pakistan in the earlier part of its history was heavily dependent on Customs duties for revenue mobilization. However, after tariff rationalization as a requirement of GATT and WTO, Customs duties in overall revenue registered a significant decline. The major indirect tax that FBR is collecting at present is Sales Tax which to a large extent is collected from each step in the production and distribution chain but its final burden is borne by the consumer (although due to myriad exemptions and evasion thetaxation is far from uniform). [Office3] In other words it is a tax on consumption of goods and services. A tax on consumption can be designed in a manner to promote equity in a tax system. It is also not a secret that consumption is also a function of income; higher the income higher the consumption. Consumption patterns also change with the level of income. For lower income strata the major share of income is expended on food items. Our sales tax law, by exempting raw and unprocessed food items attempts to provide relief from the burden of tax to the poorer sections of the society. The modern tax literature also emphasizes employing consumption taxes for disincentivizing consumption and promoting savings. However, it is not being argued that Pakistan’s sales tax system is ideal and its design cannot be improved [Office4] substantially. A general critique on the basis of indirectness does not lend itself to analysis of what objectives of tax policy make it undesirable.

7.2.2    Progressivity is a property of overall tax system, and all individual tax instruments need not be progressive to achieve redistribution. The most efficient instruments for redistribution are a progressive income tax and cash and in-kind transfers. The sales tax exemptions (or reduced rates) that serve no purpose other than redistribution should be eliminated. Relatedly, the distinction between direct and indirect taxes is quite arbitrary. For example, income tax and sales tax are economically equivalent but one is called direct and the other indirect. The distinction is unhelpful—creates political resistance against the expansion of consumption-based taxes—and should be dropped..

7.3  Simple, unified,  broad-based tariff rates:

7.3.1    For tax on traded goods, the economics literature supports having a single unified rate as the superior way of tax collection when focusing on revenue collection. For example, Roberta Gatti in his paper “Corruption and Trade Tariffs, or a Case for Uniform Tariffs” concludes that “opting for a uniform tariff on import goods can deliver higher revenues and welfare than optimally-set (Ramsey) tariffs when corruption is pervasive. This happens because uniform protection on imports restricts the ability of customs officials to exploit the wedge between tariff rates on different goods and thereby appropriate government revenues and impose efficiency losses on the economy.”

7.3.2    Even where economic considerations broader than revenue collection are taken in to account, which are often used as justification for non-uniform tariff, such as industrial policy, it is often the view that using tariffs for this purpose is not the first best solution. David G. Tarr, the then Lead Economist of The World Bank in his 2000 paper “On the Design of Tariff Policy: A Practical Guide to the Arguments for and Against Uniform Tariffs” has this to say about use of tariff for “Infant Industry and Restructuring Protection”:

“Thus, a tariff does not correct the problem. Indeed, it has been shown more generally that the best intervention is a policy that attacks the problem at the source (Bhagwati and Srinivasan, 1969). In this case, appropriate interventions directed at the source of the distortion, which could be imperfect appropriability, labor turnover, or capital market imperfections, are not tariffs, but rather measures such as the provision of information, patent protection or more effective use of instruments to allow collateral.”

7.3.3    However, as the author notes in the article, in practice, “a large number of countries have granted exceptional levels of protection for a limited number of products. The list of these countries includes some of the poorest countries but also some of the most prominent OECD countries”. This indicates that countries still find it hard to use the direct approaches for the industrial policy and still rely on tariffs as one of the tools. As such the idea of uniform tariff is to be taken more as a guiding principle.

7.3.4    The recommendation, then, by the author is Concertina Approach: “If a uniform tariff structure is to be approached, sequentially, priority should be given to reducing the highest rates. The costs in the form of the inefficiencies in resource allocation rise more than proportionately with the height of the tariff. As a consequence, the greatest gains will come from reductions in the maximum rates.”

7.3.5    Over time the tariff rates in Pakistan have been gradually reformed to reduce slabs and range of tariffs while keeping in place the Cascading Principle. This principle means less tariff rate for raw materials, and intermediate goods, as they are inputs for the domestic manufacturing sector (unavailability of domestically available competing substitutes), and highest rates for finished products/consumer goods. The progression in rationalization of tariff in slabs and range between floor and ceiling is given in Table 2 below:

Table 2: Tariff slabs in Pakistan

YEAR	SLABS	FLOOR	CEILING
2012-13	8 to 7	0%	35% to 30%
2014-15	7 to 6	0% to 1%	30% to 25%
2015-16	6 to 5	2%	25% to 20%
2016-17*	5 to 4	3%	20%
2017-18	4	3%	20%

The existing tariff comprises 7352 lines. With the exception of 48 tariff lines which carry a specific tariff (on vegetable oils, silver, gold and cellular mobile phones), all lines are ad valorem. Almost half of the imports clear under lowest slab of 3%, as is evident from below mentioned data:-

Table 3: Duty-slab-wise share of imports

Duty Slab	(Jul-Mar, 2017-18 – Rs. in Million)
	Import Value	% Share in total import Value
3%	2,406,295	50
11%	1,056,949	22
16%	193,902	4
20%	638,541	13
30-100%	228,113	5
SPECIFIC	251,963	5
G. Total	4,811,727

7.3.6    As much as these efforts at reform of tariff and focus on industrial policy are appreciable, there is a strong chance that a significant influence in determining these tariffs is to protect entrenched interests and to prevent competition. The key insight in the above referred article regarding use of tariff for industrial policy through cascading/ escalating tariff structure is:

“This “escalating” tariff structure tends to favor final goods production at the expense of intermediates, and in the long run encourages assembling type activities. That is, intermediate goods production is discouraged because it is disfavored relative to final goods and assembling activities. Thus, because an intermediate goods industry doesn’t exist today to lobby for equal protection, incentives are established which hinder its eventual creation.”

7.4  Return Filing

7.4.1                The claims appearing in sections of the press regarding a decline in the number of return filers are unfounded. For example it has been reported that FBR received 1,443,414 income tax returns in 2011 and the number was 2.1 million in 2006-07. It has been alleged that FBR is hooked on easy collection and is not interested in forcing non-filers to submit their returns. This is far from the actual position as in the year 2006-07 the actual number of returns received was 873,360 and in 2011-12 the number was 675,413. FBR was able to collect 1,546,291 returns in the last year. Therefore, the claim that FBR is losing filers is not borne by figures. The last date for filing of returns for the tax year 2018 is 30th November 2018 and the final number will surpass the returns filed for the preceding year. [Office5] 

7.4.2                FBR actually resorted to some gimmicks in the past for inflating the number of returns and the authors of the above mentioned reports were probably misled by these reports. In the Finance Act of 2005 an amendment was made in the relevant provision of law and thereby the salaried taxpayers were exempted from filing of returns if the employer had filed the withholding statement and this statement was treated as filing of returns by the employees. Therefore, if a large employer filed a withholding statement in respect of for example 100,000 employees it was treated as 100,000 returns having been filed by the employees and credit was claimed accordingly. This amendment was withdrawn through the Finance Act 2013 and the employees became liable to file proper returns of income.

7.4.3    The fluctuation in the number of returns between the years 2006-07 and 2011-12 was a result of the enhancement of the threshold of taxable income. The basic threshold above which the income becomes taxable remained static at Rs 100,000 from 2004 to 2010 for non salaried taxpayers and from 2004 to 2006 for salaried taxpayers registered a substantial four-fold increase to Rs 400,000 by 2012. This enhancement was not accompanied by a similar increase in incomes and therefore the number of returns was bound to fall over this period. The correct position is that the number of filers has more than doubled since 2011-12 and although the number is not satisfactory by any stretch of imagination but still reflects a steady growth over this period.

7.5  FBR Taxes to GDP Ratio

7.5.1                In insufficiency of the revenue collected by the state in Pakistan is evident from the tax to GDP ratio given in Figure 1 which gives the ratio of tax collection by FBR to the GDP. It has mostly hovered between 8 to 10 and for 2017-18 it was 11.2. Since the revenue collection by provinces is only 1% of GDP, the overall position of revenue collection in Pakistan is quite dismal.

7.5.2                Even an increase of a few percentage points in Tax to GDP ratio requires a herculean effort since it is tantamount to reshaping that much portion of the national economy. Change in economy to that extent can substantially change certain sectors of economy and creates many winner and losers. And when one end of the deal is held by state as the tax collector trying to increase its share, most of the losers on the other end will be entrenched stakeholders benefiting from the status quo, be it tax evaders or compromised tax collectors. Of course, if state has more resources to provide necessary services, in the long run the people of Pakistan will be better off. But these benefits are diffused and delayed, and the losses are concentrated in the hands of a few and immediate, creating a strong resistance to any tax reform effort.

7.5.3                It also appears from the trajectory of Tax to GDP ratio over the years that improvement is possible and tax reform efforts have borne fruit at least in the short term. The tax collection depends on so many factors that it is not possible to isolate the efforts of reform but both the Tax Administration Reform Project (TARP) supported by World Bank and reforms under taken during IMF – Extended Fund Facility (IMF – EFF) resulted in improvement in Tax-GDP ratio. The gains under TARP, the main phase of which was launched in 2005 and completed in 2011, were short lived in term of TAX-GDP ratio and mostly lost by the time the project ended. However, it is difficult to determine whether it was due to the nature of reforms or the financial crisis that hit the world in 2008. There was also a change in government in Pakistan in 2008 further complicating the matters.

Figure 1: Ratio of Taxes collected by FBR to GDP

7.5.4                TARPalsonever aimed at increasing tax-to-GDP ratio.   Definitely a serious mistake in the hind sight, but TARP focused mainly of “soft” reforms, while harder reforms were postponed till later. These soft reforms perhaps lay the basis for the cumulative increase during the harder EFF reforms. The main reform that worked during the EFF period was the base broadening due to reduction in exemptions, which provided the most needed trend shift in tax-to-GDP ratio.  The progress is impressive if compared end-point to end-point (i.e., 2013-14 to 2015-16) especially considering slow growth in Large Scale Manufacturing sector (the main stay of revenue generation in Pakistan). However, the progress dampens a bit when we compare average of the period with the average of the previous period.

7.5.5                This impressive tax performance conceals the fact that a significant portion of increase in tax revenue continues to come from additional revenue measures (including removal of exemptions).  The buoyancy of FBR taxes continues to be low. In other words, lower the volume of additional tax measures, lower the increase in tax-to-GDP ratio.  Until the fast growing sectors (e.g. services) are adequately taxed,we will continue to have a problem with growth in tax-to-GDP ratio.  For this, provincial taxes are critically important as indirect taxation of services is a provincial subject.

8.    Issues related to Administrative Reforms:

8.1  Sales Tax Refunds to Exporter:

8.1.1      An important area from broader economic perspective is is sales tax refunds for exporters. It is common practice for exporters to be zero-rated (the idea being that the good will pay tax when it is imported into the destination country so taxing it upon leaving Pakistan would mean taxing it twice). This zero-rating usually leads exporters to have negative sales tax liabilities, making them eligible for refunds on the tax they paid on their inputs. In practice though, these refunds are extremely slow and onerous to claim. Exporters, understandably, hate this. It raises their costs, and they may pass some of this on to their clients, raising the price of Pakistani exports and reducing Pakistani exporters’ competitiveness. From FBR’s point of view, this is understandable though: There are many many firms that issue fake sales tax invoices (the so-called “flying invoices”) allowing firms to claim fraudulent sales tax refunds. With limited capacity to detect fraudulent claims, FBR is forced to rely on slow, manual, checks of claims, leading to the aforementioned problems.

8.1.2      The other side of this issue is that the very issue of non-issuance of refunds was the basis of the granting zero-rating/ reduced rates of sales tax to the five export oriented sectors. However, there is not justification to not tax the local sales in these sectors at normal rates. This is a massive distortion and yet another example of solving an administrative failure (delay in issuance of refunds to exporters) through policy (zero-rating of entire sectors). As is generally the case, failure to adopt the first best solution of directly taking remedial administrative action to solve the problem and instead resorting to indirect approaches creates additional distortions while keeping the original issue unresolved.

8.2  Inadequate capacity to utilize available information

8.2.1    While much is said about the problems the challenges faced by revenue collectors due to large part of economy being informal, cash-based and undocumented, a no smaller problem is the weak capacity of the tax authorities to generate optimum revenue even where the basic information about potential tax evasion is available. This problem manifests itself at two levels. On the one end is the case of persons outside of tax net regarding whom information from various sources about their assets, expenditures and income is available but FBR has failed to use that information to bring these persons in to the tax net and collect due taxes. On the other end are cases of big taxpayers, where despite setting up of special units such as large taxpayers units, FBR has failed to develop expertise which can properly audit large groups of deeply interconnected companies, complicated financial arrangements, transfer pricing and sectors requiring specialized industry knowledge.

8.2.2    The case of failure in broadening tax base by identifying new taxpayers through information collected through various sources is worrisome because it is one of the most basic functions of tax administration. Here the main cause is failure to develop expertise and tools that can make sifting through reams of data using sophisticated data analysis techniques to identify the most potent cases, computerized management systems to process and monitor the progress of these cases and the administrative capacity to process these cases. [Office6] The failure to develop the requisite skills and tools means that ultimately the efforts spent on broadening of tax base yield little revenue and thus considered by field offices as waste of resources that can be utilized to meet more immediate budget targets. This leaves a permanent gap in realizing full revenue potential. [Office7] 

8.2.3    The failure to properly audit the big taxpayers, who are resourceful enough to be capable of utilizing every conceivable loophole to avoid paying taxes and then some more, leads to gaps in tax collection that cannot be filled by thousands of small new taxpayers. The old administrative structure is just not capable of delivering on this front and the whole administrative and legal scheme of such audits needs a major review.[Office8] 

8.3  Morale of Tax Administration:

8.3.1    Staff morale within tax administration is low as the general perception is that both human resource management and business decisions are made in a non-participatory top-down manner, general ignoring the capacity constraints and ground realities.A shift in tax administration towards more inclusive and participatory decision-making can help improve staff morale.

8.4  Exchange of information:

8.4.1    The exchange of information between the tax administrations of different jurisdictions is increasing rapidly. Cross-border transactions have increased manifold in recent times. Incidence and extent of evasion through such transactions has also multiplied. This has resulted in greater international cooperation on sharing information. FBR has taken several steps to ensurebecoming part of this process. However, there is a need to establish systems to take full benefit of this opening and utilize information to detect tax evasion in individual income tax as well as under-invoicing of import taxes and evasion of corporation tax through profit shifting and other such activities.

8.5  Facilitation by pre-population of tax returns

8.5.1    FBR receives a lot of third-party information from its withholding taxation or its access to other government databases. This information can be used to generate pre-populated tax returns. These partly filled in returns should then be sent to every potential taxpayer who should be able to amend/edit them before filing. This policy is practiced in a number of countries and ensures that taxpayer at the minimum report income larger than the third-party-reported transactions. 


8.6  SocialRecognitionofTopTaxpayers

8.6.1    In order to promote tax culture, the governmentshould take steps to for social recognition of top taxpayers. This will create a support for payment of tax a civic duty.

8.7  Technology-based Solutions

8.7.1    Recently a technology based solution to discourage the smuggling of mobile phones was introduced. In a similar example, adding a red dye to fuel meant for domestic heating in the US (exempt) has drastically reduced its misuse in transportation (taxable). Such technological solutions are available for a number of industries (such as tobacco) and must be tried where feasible. 


8.8  Machine Learning:

8.8.1    FBR should develop algorithms to detect tax evasion in the country. Such machine learning tools are now deployed by most sophisticated tax administrations 
around the world. They use information the tax administration acquires through internal and external sources to continuously detect patterns and incidence of tax evasion. To train and sharpen these model, FBR should work with stakeholders including the industry to develop input output ratios of major supply chains in the country.

8.9  Whistleblowing

8.9.1    Whistleblowingisanimportantdeterrentoftaxevasion.Agoodwhistle- blowing programme must be known widely. It must make the provision of information through potentially anonymous sources as effortless as possible. And it must have a mechanism to ensure the protection and compensation of whistleblowers. The existing FBR programme lacks these features and needs to be revamped along these lines.

8.10                     Urban Immoveable Property Tax (UIPT):

8.10.1  Based on assessed rental value of property, UIPT was designed as a revenue source to finance municipal services. In other words, the tax (or at least revenue) belongs to the Tehsil/Town Municipal Administrations (TMAs). The revenue however, is collected by the provincial government (Excise and Taxation Department) and suffers from a host of problems, including weak ownership (as bulk of revenue is transferred to TMAs on collection bases), low assessment of rental values, large scale exemptions and poor enforcement. The extent of tax gap could be ascertained from the fact that total UIPT collection in Pakistan in 2016-17 was Rs 4.5 billion. Where in the same year, one city alone (Mumbai) in India and equivalent of Rs 27 billion (in Delhi collection was Rs 6 billion and in Bengaluru Rs 15 billion). The fundamental difference is that in India, property tax is collected by the city governments, whereas in Pakistan it is collected by provinces. Starting with larger TMAs (City Governments), UIPT should be devolved to TMAs in a phased manner.

8.10.2  According to a study by International Growth Center of the issue in Punjab, the tax administration of UIPT suffers from infrequent updation of valuation tables, lack of incentives to motivate inspectors, exemptions, poor coverage and high tax rates.

Recommendations

The recommendations are arranged in the same order as the issues discussed earlier.

4.    Conceptual issues in tax design

4.1             Tax design and objectives of tax policy:

1. The annual budget exercise that announces changes in tax policy for the next year is not an appropriate and sufficient document to provide guideline for medium to long term tax policy direction. The long term objectives of the tax policy would be too broad and general to provide useful immediate guidance. The appropriate solution to the need for guiding principles for tax policy guide line is an annual Medium Term Tax Policy Framework that should indicate the direction of tax policy over the next few years. A Medium Term Budget Framework is prepared each year but it does not contain details of Tax policy.
2. A Medium Term Tax Policy Framework would provide an opportunity for the government to delineate its tax policy over the next few years. It would also convey to the businesses the direction of tax policy providing stability and helping them in planning. More importantly it would provide a platform for elaborating the principles and objectives of tax policy at a more granular level providing guidance about priorities in different areas of tax policy planning and administration. 
3. The annual budgetary proposals, currently ad hoc,would have to be consistent with the more medium term direction of the tax policy.This will allow pre-budget vetting of proposals to ensure consistency between the two. For that the medium term tax policy document should be in place. This is an important recommendation.We should suggest the institutional framework (FBR not make tax policy; setting up atax policy board/Commission) for this up front rather than later in the document.

4.2             Loss of Focus of Tax policy vis-à-vis Economic Policy

 

1. Law should be enacted to ensure that no tax exemptionto be allowed though law or notification without an estimate of its cost independently by the tax department as well as the concerned ministry. Such cost shall be made public.
2. All the existing exemptions may be reviewed. Even if an exemption is to be retained its cost should be determined and made public.
3. All exemptions, existing or newly proposed, should have a sunset clause. Even where an exemption is desired to be continued indefinitely, it should expire after a period of five years and should be reenacted after that with redetermination of the costs.
4. A list of all government owned enterprises availing exemption/ concession in any way along with quantification of the tax expenditure should be published and a plan for phasing out of these concessions should be prepared to remove this distortion from the market.
5. Take the power to write SROs away from FBR. Only parliament should be able to grant exemptions after the proper, public, debate, making them accountable to voters. Progress towards this was made in the last budget.
6. All non-procedural existing SROs should expire at the end of the fiscal year. In the last two years steps were taken to incorporate all exemptions granted through SROs to be made part of the body of law.

4.3             Loss of Focus of Tax policyvis-a-vis Tax Administration

 

1. The focus of FBR should be strengthening of tax administration.
2. The function of Tax Policy making should not be responsibility of FBR and FBR should focus on administering and enforcing the tax code. The capacity for developingtax policy outside FBR will take time.A suitable location for developing such capability, can be parliament. This will have the advantage of long term strengthening of parliament and providing informed input to the opposition members as well.
3. Another alternative can be establishment of a Policy Board for approval of all policy proposals. This can be immediately implemented and will provide a necessary corrective and check on the policy making process at FBR. 

5.    Issues related tofederalism and fragmentation of taxes

5.1  Fragmentation of Tax System:

1. This is a complex problem and improving the solution would require willingness to work together by a diverse array of stakeholders. The very first step, that is being taken through this report, is to bring this item on national agenda to start a national conversation about how to approach this problem.
2. A concrete step would be establishing a high-powered Tax Commission comprising area experts and federal and provincial representatives. The Commission should define parameters of a tax system which is well integrated across levels of government.

5.2  Fragmentation of Sales Tax between Federation and States:

 

1. Anarrangementwithout any change in constitution, is possible where the center can collect taxes but they do not form part of Divisible Pool but are directly transferred to provinces. This will make the administration of Sales Tax more efficient and consistent and greatly reduce cost of doing business. Any such arrangement will have to be cognizant of the concerns about impact on revenue collection due to ownership of tax. A mechanism to ensure that the focus of the center remains on proper revenue collection of a tax from whichit gets no share shall be a part of such arrangement.
2. Alternate option can be to harmonize the tax code and integrate certain processes. In this case the provinces and center will have similar harmonized tax codes, an integrated automated front end for the taxpayerperform all actions that need to be done voluntarily including filingjoint tax returns and automated exchange of information. This will reduce the cost of doing business to some extent and make it harder for taxpayers to play the tax administrations off against each other to evade taxes.
3. Another solution can be to hand over collection of tax on service in sectors that generally operate in multiple provinces to the center since they are the one most troubled by fragmentation. For the rest of the services, the provinces can keep collecting Sales Tax on services but withand integrationand harmonization of the proceduressuch as filing joint tax return.

5.3  Taxing Income from Agriculture:

1. The solution to this might lie in handing over the collection of Income Tax on Agriculture Income to the federation. The resultant tax collected in respect of each province should not form part of the divisible pool and can be directly transferred to the respective province. The provinces can still retain the constitutional right as well as policy decision making of the taxation of the agriculture income.[Office9] 
2. The integration of the taxation of all sources of income will result in reduction in administrative costs, simplification of procedures, increased documentation and less opportunities for tax evasion. It will also, at least in the short term, force smaller agriculturists to deal with new bureaucratic institution, impose higher tax cost on many agriculturists (at least this is the hope) and extend pathologies of the existing federal tax administration to a new sector (although it will replace the problems with provincial tax administration). Any such arrangement is also likely to face political resistance on account of principles of fiscal federalism, bureaucratic resistance from provincial tax administration and public resistance from those who are beneficiaries of existing low tax collection. However, in the long run, if Pakistan has to achieve its full income tax potential, one-fifth of the economy cannot remain hostage to a colonial era tax collection system.

6.    Issues related to major tax evasion

6.1  Real Estate Sector:

1. Since the federal government collects tax on income from property and provincial and local governments collect property tax on immovable property, all parties have an interest in proper documentation and valuation of property. It is also important to approach the taxation in a way to not push it further in the informal sector.
2. While various steps to bring this sector in the tax net, as discussed elsewhere, may be taken, it is recommended that this matter may also be taken up by a National Tax Commission to develop a coordinated approach to coordinate the taxation and valuation of the sector in a way to collect optimum revenue from it without discouraging investment.

6.2  Under-invoicing and underreportingof Imports:

1. A study aimed at measures to curb under-invoicing through improvements to the risk management algorithm, remote clearance(clearance of imported goods at one port by staff stationed at another port) and anonymization all of which are techniques which have proved successful in other countries.
2. A study to identify the tax losses from under-invoicing at import stageinthesales tax value addition chain.
3. A study to estimate the extent of imports that disappear in the informal sector.
4. Steps for making it easier to track the use of imported inputs through better links between the customs data and the sales tax data. This can be a source of large potential gains in sales tax enforcement.[Office10] 

6.3  Smuggling:

1. In order to maximize revenues, the government may adopt a Unified Approach that incorporates the core values of trade facilitation, drawing extensively upon principles of risk-mitigation and effective enforcement. The overall impact would be to gradually and significantly impact the “trade” through informal channels, which in turn would increase legitimate imports and ultimately be instrumental in maximizing revenues.

7.    Discussion on some structural issues

7.1              Withholding Taxes

1. Withholding taxes serve many useful tax policy purposes in an undocumented economy as well as fiscal policy (such as pay as you go and consistent stream of revenue). However, there is a clear tradeoff as well that results in favouring withholding tax by the government even where they do not serve these purposes: Withholding taxes allows the government to collect income taxes even when the capacity of the tax administration is low. On the other hand, withholding taxes may be regressive if they are paid by people who are not liable to income taxes and/or if firms treat them as consumption taxes and they are passed through to consumers. It is proposed that a study may be conducted to analyze these various factors and categorize different withholding taxes according to desirability of maintaining, amending or phasing out them.

7.2  INDIRECT TAXATION

1. In the complex tax system of Pakistan, detailed studies should be conducted to understand the true impact and incidence of different taxes on citizens.

7.3  Simple, unified, broad-based tariff rates:

1. A major review of tariff is required in the light of these considerations and in most cases it is best to let the market determine the most efficient allocation of resources. If 50% of imports are cleared at 3% tariff and another 22% at 11%, it is even more important to review the rest of the slabs.

7.4  Return Filing

1. The focus on tax returns remains and will continue to remain since it is indicator for two important things. First, despite the steady growth in number of filers there are still many hundreds of thousands of people who should file and don’t. Even where additional revenue from many of these people is small, they leave a gap in the documentation that allows other taxpayers to evade taxes. Therefore, the focus on increasing the number of return filers should remain. The utilization of spending data for increasing number of filers is discussed separately in detail.
2. In developed countries, one reason for high number of return filers is that it is linked to social welfare system through various income tax credits. This results in high number of tax refunds. For in example, in US nearly 8 in 10 return filers get a tax refund. It is possible to define a scheme where small taxpayers who claim excess deduction of tax from certain withholding heads are automatically refunded a part of their refund claim through direct deposit in their bank accounts. This will cost a few tens of billions, depending upon the design of the scheme, but will result in vastly improved compliance, goodwill for the government, increased documentation and promotion of tax culture.
3. Most of the returns that are filed are underreporting income. In a voluntary compliance regime, tax filing is the main point of contact and documentation point between the taxpayer and tax administration. Enhanced capacity for data analysis, linking spending data with income tax filing, risk analysis and specialized audit are necessary to detect and deter this underreporting.

8.    Issues related to Administrative Reforms:

8.1  Sales Tax Refunds to Exporters:

1. This is a key area where greater and better use of technology can help detect fraudulent claims and speed up claims for honest taxpayers. Using these techniques prompt issuing of refunds within strict time line should be ensured.
2. If the problem of refunds is solved, there is no justification of taxing local sales at low rates. The standard tax rate for domestic sales should be introduced gradually and may start with high value products first.

8.2  Inadequate capacity to utilize available information

1. There are two very important issues discussed together here. The first is identifying and pursuing individuals falling outside the tax net through the use of third party information on consumption patterns utilizing data from income, income tax returns and expenditure data from various sources such as travel, bank account, car ownership, property ownership, children studying abroad, children studying in expensive schools etc. This data can be used to estimate and analyze the relationship between income and expenditures on different goods and services. The resultant relationships can provide parameters to identify tax liability of people who were not registered in the system.
   1. Since FBR does not have adequate capacity to utilize this data using latest techniques available, it would be necessary to collaborate with researchers and experts to develop efficient and effective analytical tools.

8.3  Morale of Tax Administration:

1. A shift in tax administration towards more inclusive and participatory decision-making can help improve staff morale.

8.4  Exchange of information:

1. There is a need to establish systems to take full benefit of theinternational exchange of information agreements and utilize information to detect tax evasion in individual income tax as well as under-invoicing of import taxes and evasion of corporation tax through profit shifting and other such activities.

8.5  Facilitation by pre-population of tax returns

1. FBR shouldgenerate pre-populated tax returns. These partly filled in returns should then be sent to every potential taxpayer who should be able to amend/edit them before filing. 


8.6  SocialRecognitionofTopTaxpayers

1. In order to promote tax culture, the governmentshould take steps to for social recognition of top taxpayers. This will create a support for payment of tax a civic duty.

8.7  Technology-based Solutions

1. Technological solutions are available for a number of industries (such as tobacco) and must be tried where feasible. 


8.8  Machine Learning:

1. FBR should use machine learning tools that use information the tax administration acquires through internal and external sources to continuously detect patterns and incidence of tax evasion. To train and sharpen these model, FBR should work with stakeholders including the industry to develop input output ratios of major supply chains in the country.

8.9  Whistleblowing

1. Whistleblowingisanimportantdeterrentoftaxevasion.Agoodwhistle- blowing programme must be known widely. It must make the provision of information through potentially anonymous sources as effortless as possible. And it must have a mechanism to ensure the protection and compensation of whistleblowers. The existing FBR programme lacks these features and needs to be revamped along these lines.

8.10                     Urban Immoveable Property Tax (UIPT):

1. In order to finance provincial entities (e.g. WASAs and Development Authorities, a revenue-sharing arrangement could be worked out with TMAs; including the possibility of province “piggy backing” the tax.
2. The task force on tax reform set up by Punjab government recommended that period between surveys/ re-assessments be reduced to 3 years from 5 years or tax demand be inflation indexed, tax rate be reduced and gradually parity be achieved between self-occupied and rented properties. These recommendations, which were expected to increase the revenue four fold, are still applicable today.

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[1]Levi, M. (1988). Introduction of the Income Tax in Eighteenth-Century Britain. In Of Rule and Revenue (pp. 122-144). University of California Press. Retrieved from http://www.jstor.org.ezp.lib.unimelb.edu.au/stable/10.1525/j.ctt1pngtk.10

[2] Economic Survey of Pakistan 2017-18, Chapter 4, Table 4.1

[3]http://www.doingbusiness.org/en/data/exploreeconomies/pakistan#DB_taxaccecced October 3, 2018.

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 [Office1]If changing the constitution is off the table, two intermediate options are available:

1-FBR to collect all sales taxes on behalf of both the federation and the provinces and then distribute the revenues.

2-If this isn’t an option politically, to have automatic information sharing on sales taxes between the federation and the provinces (in both directions).

The reason these may have a big impact is because they centralize administration, making it harder for taxpayers to play the tax administrations off against each other to evade taxes. The first option may be particularly attractive if we think that FBR has better administrative capacity than the provinces to administer taxes.

 [Office2]This is important. There is a clear tradeoff here: Withholding taxes allows the government to collect income taxes even when the capacity of the tax administration is low. On the other hand, withholding taxes may be regressive if they are paid by people who are not liable to income taxes and/or if  firms treat them as consumption taxes and they are passed through to consumers. This is why I proposed to study this with the available data (plus the help of some surveys of prices).

 [Office3]This is only true if a) all goods face the same rate (i.e. no exemptions or zero-rating along the production chain) and b) enforcement of the tax is perfect. Neither of these apply to the Pakistani case. In this setting, it’s very hard to know what the true incidence of the sales tax is. Again, this is why I wanted to study this.

 [Office4]This is  politically very sensitive, but it bears mentioning here: There are also a range of subsidies (petroleum products etc) that are very expensive and whose incidence is likely to be on relatively well off households. These are also likely to be regressive.

 [Office5]That’s great, but it’s still the case that a) there are many hundreds of thousands of people who should file and don’t. and b) that most of the returns that are filed are underreporting income.

This is the motivation for doing better at linking spending data with income tax filing and using that to increase filing rates and reduce underreporting.

 [Office6]2 points here:

1-I absolutely agree that it will be important to do better at using the data to identify cases. That’s what our project will hopefully start with. But:

2-there was (is?) a computerized management system to monitor the progress of the cases. The problem was that people in the field offices didn’t use the system, either because they weren’t properly trained, or more likely, because they had very limited incentive to work hard at following up. This should also be an important part of the IGC-FBR project on broadening the tax base.

 [Office7]Yes, absolutely!

 [Office8]I think at one point someone told me something shocking like that the number of trained auditors at FBR was on the order of 15. This is a severe bottleneck.

Given that it is such a bottleneck it makes it all the more important to deploy the limited auditing resources available wisely. Making better use of the available data both to detect risk but also to allocate human resources will be key here.

 [Office9]Yes! This also has the additional benefit that this information would be automatically available when looking at people’s federal income tax returns (in which agricultural income is an exemption)

 [Office10]

 Finding ways to reduce the scope for underinvoicing at customs is important and contemporary research tools can be applied.

The point about underinvoicing being linked to downstream evasion is also important. Imported inputs should be a valuable source of data for the enforcement of sales taxes downstream. Sadly, this is not the case. The underinvoicing problem is real. Another problem that may be even larger is that a lot of the imported inputs “disappear” either into the informal sector or as inputs to sales-tax liable firms whose outputs are then underreported. Making it easier to track the use of imported inputs through better links between the customs data and the sales tax data is a source of large potential gains in sales tax enforcement.

One thing that’s important that is not mentioned here is sales tax refunds for exporters. It is common practice for exporters to be zero-rated (the idea being that the good will pay tax when it is imported into the destination country so taxing it upon leaving Pakistan would mean taxing it twice). This zero-rating usually leads exporters to have negative sales tax liabilities, making them eligible for refunds on the tax they paid on their inputs. In practice though, these refunds are extremely slow and onerous to claim. Exporters, understandably, hate this. It raises their costs, and they may pass some of this on to their clients, raising the price of Pakistani exports and reducing Pakistani exporters’ competitiveness. From FBR’s point of view, this is understandable though: There are many many firms that issue fake sales tax invoices (the so-called “flying invoices”) allowing firms to claim fraudulent sales tax refunds. With limited capacity to detect fraudulent claims, FBR is forced to rely on slow, manual, checks of claims, leading to the aforementioned problems. This is a key area where greater and better use of technology can help detect fraudulent claims and speed up claims for honest taxpayers.