No serious effort has ever been made in Pakistan to to come up with a tax policy that encourages industrialization through the corporatization of business, leading to economic growth and documentation of the economy. Instead, the sole stress on irrationally fixed revenue targets has created an ugly fiscal mess. Pakistan has, as a result, been pushed into a ‘debt prison’. Civilian and military governments alike have failed to broaden the tax net and crack down on untaxed assets and ill-begotten wealth.
One of the main jobs of a tax policy is to increase savings and capital formation in the private sector, partly for borrowing by the government and partly for enhancing investment resources within the private sector for economic development. In Pakistan, however, in recent years we have instead seen large industries close down and growth stagnate. The country has been deprived of capital because of corruption and the incompetence of the Federal Board of Revenue (FBR). Inconsistent tax policies have forced the business community to search for safer havens abroad. Foreign investors are reluctant.
Pakistan is one of those fortunate countries that has an abundance of resources and a versatile climate but thanks to a donor agenda that pushes retrogressive taxation, and the incompetence of our economic ‘wizards’, we have grown more dependent on imports. We ignore exports and have not supported high-tech industries, which are so crucial in modern knowledge-based economies.
Foreign direct investment (FDI) has actually nose-dived in the last decade. In Pakistan, where local investment is dying, it is foolish to expect FDI, which is needed for technological transfers, rapid industrial growth and jobs. Tax incentives are linked to attracting FDI but our budget makers have always been preoccupied with revenue targets not long-term investment-oriented tax incentives for infrastructure development, investment and job creation, without which sustainable growth is not possible.
Foreign investors will not come to Pakistan as long as there are unsatisfactory law and order conditions and an energy shortage. These and other factors are why even existing industrial units are closing down or working at low capacity. Nobody is willing to invest in special economic zones, where tax incentives are available, because of a lack of infrastructure. Industrialists—fearing loss of life and property, extortion, power shortages, rising costs of doing business and hostile tax policies—are moving their capital abroad. Tax incentives do matter but not as a first priority—any feasible growth-oriented project can be profitable after paying reasonable taxes. In Pakistan, corporate taxation in 2016 is still as high at 42%.
Right now only about 68,000 companies are registered with the SECP out of which only 24,000 are active and file tax returns. These companies are maltreated by the FBR; after collecting billions of rupees as ‘collection agents’ of the State without any compensation, they are penalised for small lapses that are neither intentional nor willful. There are also numerous anti-corporate provisions in the tax codes. Taxation of notional benefits e.g. concessional loans in the hands of employees, a high corporate tax rate and double taxation of dividends and reserves out of already taxed profits are just some examples.
Under these circumstances, no one would like to do business through a company, especially when audited accounts by independent and credible auditors are rejected on a whim and without the taxation officers giving proof on the record. Companies then have to hire expensive lawyers to get justice. Small wonder then that Pakistan’s ranking has gone from 136 to 138 in the World Bank’s ‘Doing Business 2016’ data.
The corporate sector suffers the worst from the FBR’s arid policies. The board’s myopic outlook is evident from its over-emphasis on withholding taxes. With low tax rates we could have promoted corporate growth. On the contrary, in 2015 the FBR imposed a ‘tax on undistributed reserves’, ignoring that reserves are created from already taxed income. Minimum taxation on service sector companies was another bad move. In 2014, the FBR imposed an ‘Alternative Corporate Tax’. Such erratic, arbitrary and expropriatory taxation just retards corporate sector growth.
In short, the government has done all that it could to make the life of a compliant taxpayer miserable. People are also loathe to pay their taxes because it is extremely complicated. Educated people struggle to follow the rules. Elected representatives should pass a law creating a national tax authority that would collect all taxes. People would just have to deal with one single revenue authority rather than agencies at the national, provincial and local levels. There are multiple tax collection authorities now, which is why people have to pay professionals to figure out their returns. The helplessness of seeing hard-earned money go down the drain has compelled many people to look for greener pastures where their taxes trickle down to benefit them.
Indeed, instead of using taxes on the people, 65% is spent on servicing debt alone. Our total debt is about 68% of GDP and it is going up. The last government added Rs6.3 trillion to the burden (a 103% increase) and the record of the present government is equally appalling. It has been borrowing heavily to pay earlier debts. It pushed debt servicing alone to Rs1.5 trillion in 2015–16. This was nearly 68% of total revenue collection. The borrowing to bridge the fiscal deficit is estimated to cross Rs2 trillion this year.
On the other hand, the provinces wring their hands over the the inefficiencies in the FBR because they are not getting enough from the divisible pool is meet their budgets. Since every province’s share of federal taxes depends on how efficiently taxes are collected by the FBR, it is important for the centre and units to participate in tax collection. No serious debate has ever taken place on how we should increase the size of the pie to ensure that governments have enough funds to run.
The provinces should feel that they are responsible for tax collection. Right now they are isolated and rely on distribution from the divisible pool while the FBR collects less than its targets. The responsibility to collect revenues should be joint, which would give the units a sense of ownership and participation.
Thus, we have gone from having a tax compliant public to a tax rebellious one, from a high tax-to-GDP ratio to an obnoxiously low one. We used to have greater revenue from fewer taxpayers (2m) but now have very low revenue from a broad-based population (20m). We have gone from a relatively thriving economy with low debt to an apparently prosperous one in which debt is 68% of GDP. We have gone from a greater reliance on direct taxes to a complete turn-around towards indirect ones.
What we need is a debate on an efficient tax model and a study of all the irritants in tax codes, procedures and implementation. Here is what we offer as remedies aimed at incentivising rapid growth and voluntary tax compliance:
Flat taxation
The solution is to dismantle the system and switch to a flat rate. All taxes should be merged into one single tax with complete assurance to people that they will not be harassed and the money would be spent on their welfare. A simple flat rate tax would be neither burdensome nor difficult to implement (but it would be opposed by the bureaucracy and some vested interests).
The equation is simple. The federal government needs at least Rs7 trillion in revenue. Pakistan could yield a total of Rs12 trillion in taxes if agricultural income tax and other provincial and local taxes were efficiently collected. Neither the centre nor the provinces collect taxes to their potential because of weak enforcement and an outdated system.
At the federal level alone, income tax alone would be Rs7 trillion if the entire undocumented economy were brought into the net. All efforts to achieve this have failed. The tax system is to blame for encouraging a parallel economy and this won’t be fixed no matter how many tax reform commissions you make. The ever-growing size of the parallel, undocumented economy has much to do with the way taxes have been administered for the last many decades. Those who evade taxes are never punished. They are instead pardoned and appeased through various laws and amnesty schemes. As a result the informal economy grows. It is estimated at Rs30 trillion, which is almost as large as the documented economy.
If a flat tax of 10% were offered to all who have failed to pay in the past, in just one year the FBR would collect Rs3 trillion. In 2014-15 the FBR collected a mere Rs2.58 trillion against a documented GDP of around Rs24.7 trillion. People who don’t pay their taxes or don’t pay them truthfully would pay voluntarily as the rate would be minimal and the cost of compliance would be almost nil.
Considering inflation and the high cost of living, an overwhelming majority of Pakistan’s population earns less than the minimum threshold of Rs400,000 and thus dors not need to pay income tax or file returns. The number of people with taxable income of more than Rs400,000 is between 10m to 12m and the tax base is around Rs50 trillion (after taking into account the informal economy). A 10% flat tax would yield Rs5 trillion in income tax alone.
All existing indirect taxes should be replaced both at the federal and provincial levels with a Harmonized Sales Tax (HST). We have emphasized time and again that Pakistan needs an HST, which should be single-stage and single digit. Canada has done this. A single-stage 5% HST would yield at least Rs3 trillion at the federal and provincial levels.
The tax base can be achieved by imposing a 10% flat rate tax on net income of individuals and reducing corporate tax rate to 20%. People would pay on their own as long as they know that the tax machinery will be able to easily detect avoidance. This is essential as nowhere in the world can such a system work without strong enforcement.
The writers are lawyers and adjunct faculty members at the Lahore University of Management Sciences
One of the main jobs of a tax policy is to increase savings and capital formation in the private sector, partly for borrowing by the government and partly for enhancing investment resources within the private sector for economic development. In Pakistan, however, in recent years we have instead seen large industries close down and growth stagnate. The country has been deprived of capital because of corruption and the incompetence of the Federal Board of Revenue (FBR). Inconsistent tax policies have forced the business community to search for safer havens abroad. Foreign investors are reluctant.
Taxes at a glance
Pakistan's total tax potential Rs12tr Rs7tr could be collected in income tax if the entire economy were documented No of registered companies 68,000 Companies that file tax returns 24,000
Pakistan is one of those fortunate countries that has an abundance of resources and a versatile climate but thanks to a donor agenda that pushes retrogressive taxation, and the incompetence of our economic ‘wizards’, we have grown more dependent on imports. We ignore exports and have not supported high-tech industries, which are so crucial in modern knowledge-based economies.
Foreign direct investment (FDI) has actually nose-dived in the last decade. In Pakistan, where local investment is dying, it is foolish to expect FDI, which is needed for technological transfers, rapid industrial growth and jobs. Tax incentives are linked to attracting FDI but our budget makers have always been preoccupied with revenue targets not long-term investment-oriented tax incentives for infrastructure development, investment and job creation, without which sustainable growth is not possible.
Foreign investors will not come to Pakistan as long as there are unsatisfactory law and order conditions and an energy shortage. These and other factors are why even existing industrial units are closing down or working at low capacity. Nobody is willing to invest in special economic zones, where tax incentives are available, because of a lack of infrastructure. Industrialists—fearing loss of life and property, extortion, power shortages, rising costs of doing business and hostile tax policies—are moving their capital abroad. Tax incentives do matter but not as a first priority—any feasible growth-oriented project can be profitable after paying reasonable taxes. In Pakistan, corporate taxation in 2016 is still as high at 42%.
The government has done all that it could to make the life of a compliant taxpayer miserable. People are also loathe to pay their taxes because it is extremely complicated. Educated people struggle to follow the rules
Right now only about 68,000 companies are registered with the SECP out of which only 24,000 are active and file tax returns. These companies are maltreated by the FBR; after collecting billions of rupees as ‘collection agents’ of the State without any compensation, they are penalised for small lapses that are neither intentional nor willful. There are also numerous anti-corporate provisions in the tax codes. Taxation of notional benefits e.g. concessional loans in the hands of employees, a high corporate tax rate and double taxation of dividends and reserves out of already taxed profits are just some examples.
Under these circumstances, no one would like to do business through a company, especially when audited accounts by independent and credible auditors are rejected on a whim and without the taxation officers giving proof on the record. Companies then have to hire expensive lawyers to get justice. Small wonder then that Pakistan’s ranking has gone from 136 to 138 in the World Bank’s ‘Doing Business 2016’ data.
The corporate sector suffers the worst from the FBR’s arid policies. The board’s myopic outlook is evident from its over-emphasis on withholding taxes. With low tax rates we could have promoted corporate growth. On the contrary, in 2015 the FBR imposed a ‘tax on undistributed reserves’, ignoring that reserves are created from already taxed income. Minimum taxation on service sector companies was another bad move. In 2014, the FBR imposed an ‘Alternative Corporate Tax’. Such erratic, arbitrary and expropriatory taxation just retards corporate sector growth.
In short, the government has done all that it could to make the life of a compliant taxpayer miserable. People are also loathe to pay their taxes because it is extremely complicated. Educated people struggle to follow the rules. Elected representatives should pass a law creating a national tax authority that would collect all taxes. People would just have to deal with one single revenue authority rather than agencies at the national, provincial and local levels. There are multiple tax collection authorities now, which is why people have to pay professionals to figure out their returns. The helplessness of seeing hard-earned money go down the drain has compelled many people to look for greener pastures where their taxes trickle down to benefit them.
Indeed, instead of using taxes on the people, 65% is spent on servicing debt alone. Our total debt is about 68% of GDP and it is going up. The last government added Rs6.3 trillion to the burden (a 103% increase) and the record of the present government is equally appalling. It has been borrowing heavily to pay earlier debts. It pushed debt servicing alone to Rs1.5 trillion in 2015–16. This was nearly 68% of total revenue collection. The borrowing to bridge the fiscal deficit is estimated to cross Rs2 trillion this year.
On the other hand, the provinces wring their hands over the the inefficiencies in the FBR because they are not getting enough from the divisible pool is meet their budgets. Since every province’s share of federal taxes depends on how efficiently taxes are collected by the FBR, it is important for the centre and units to participate in tax collection. No serious debate has ever taken place on how we should increase the size of the pie to ensure that governments have enough funds to run.
The provinces should feel that they are responsible for tax collection. Right now they are isolated and rely on distribution from the divisible pool while the FBR collects less than its targets. The responsibility to collect revenues should be joint, which would give the units a sense of ownership and participation.
Thus, we have gone from having a tax compliant public to a tax rebellious one, from a high tax-to-GDP ratio to an obnoxiously low one. We used to have greater revenue from fewer taxpayers (2m) but now have very low revenue from a broad-based population (20m). We have gone from a relatively thriving economy with low debt to an apparently prosperous one in which debt is 68% of GDP. We have gone from a greater reliance on direct taxes to a complete turn-around towards indirect ones.
What we need is a debate on an efficient tax model and a study of all the irritants in tax codes, procedures and implementation. Here is what we offer as remedies aimed at incentivising rapid growth and voluntary tax compliance:
Flat taxation
The solution is to dismantle the system and switch to a flat rate. All taxes should be merged into one single tax with complete assurance to people that they will not be harassed and the money would be spent on their welfare. A simple flat rate tax would be neither burdensome nor difficult to implement (but it would be opposed by the bureaucracy and some vested interests).
The equation is simple. The federal government needs at least Rs7 trillion in revenue. Pakistan could yield a total of Rs12 trillion in taxes if agricultural income tax and other provincial and local taxes were efficiently collected. Neither the centre nor the provinces collect taxes to their potential because of weak enforcement and an outdated system.
At the federal level alone, income tax alone would be Rs7 trillion if the entire undocumented economy were brought into the net. All efforts to achieve this have failed. The tax system is to blame for encouraging a parallel economy and this won’t be fixed no matter how many tax reform commissions you make. The ever-growing size of the parallel, undocumented economy has much to do with the way taxes have been administered for the last many decades. Those who evade taxes are never punished. They are instead pardoned and appeased through various laws and amnesty schemes. As a result the informal economy grows. It is estimated at Rs30 trillion, which is almost as large as the documented economy.
If a flat tax of 10% were offered to all who have failed to pay in the past, in just one year the FBR would collect Rs3 trillion. In 2014-15 the FBR collected a mere Rs2.58 trillion against a documented GDP of around Rs24.7 trillion. People who don’t pay their taxes or don’t pay them truthfully would pay voluntarily as the rate would be minimal and the cost of compliance would be almost nil.
Considering inflation and the high cost of living, an overwhelming majority of Pakistan’s population earns less than the minimum threshold of Rs400,000 and thus dors not need to pay income tax or file returns. The number of people with taxable income of more than Rs400,000 is between 10m to 12m and the tax base is around Rs50 trillion (after taking into account the informal economy). A 10% flat tax would yield Rs5 trillion in income tax alone.
All existing indirect taxes should be replaced both at the federal and provincial levels with a Harmonized Sales Tax (HST). We have emphasized time and again that Pakistan needs an HST, which should be single-stage and single digit. Canada has done this. A single-stage 5% HST would yield at least Rs3 trillion at the federal and provincial levels.
The tax base can be achieved by imposing a 10% flat rate tax on net income of individuals and reducing corporate tax rate to 20%. People would pay on their own as long as they know that the tax machinery will be able to easily detect avoidance. This is essential as nowhere in the world can such a system work without strong enforcement.
The writers are lawyers and adjunct faculty members at the Lahore University of Management Sciences