Tax reforms

For any developing economy tax collection represents the most critical component for growth and development. On an average, developing economies collect less than 15 percent of GDP in taxes, compared with the 40 percent collected by advanced countries. The ability to collect taxes is central to a country’s capacity to finance social services such as health and education, critical infrastructure such as electricity and roads, and also undertake much needed public welfare schemes and projects for the most under privileged segments of the society. Given the much needed investment required in social infrastructure and public welfare the lower level of tax collection has the highest impact impeding overall economic growth and development.

Pakistan like any other developing country has long faced a tax collection crisis. Tax-to-GDP ratio in Pakistan has slipped down to 9.5% for the last fiscal year as shutdown related to coronavirus impacted the revenue collection efforts. The Federal Board of Revenue (FBR), in its revenue year book, said the tax-to-GDP ratio on the basis of FBR collection declined from 10.1 percent in FY2018-19. It was 11.1 percent in the 2017-18. The last single digit tax-to-GDP ratio was recorded in fiscal year of 2014-15. The overall situation across South Asia is more or less similar. Both India and Bangladesh the other two major countries within the Region have also faced somewhat similar issues of lower tax to GDP ratio and a corresponding decline in the recent year.

Pakistan’s narrow tax base, its limited capacity to collect taxes, and the low national rate of tax compliance all require effective reforms in both policy and the tax administration infrastructure.

The problem with widening of the tax base has also been the large number of tax exemptions available to certain segments of society. Taxes on agriculture, capital gains, and real property based on actual market based valuation, for example, are essentially negligible, shifting the taxpaying burden through withholding taxes for the salaried segment and indirect taxes, which impact the largest segments of the population.

Whereas there has been a continued need to reduce exemptions, however no such reductions have been reflected through any major reforms or changes in policy with only selective reduction for smaller sub segments of the economy or industry. Such exemptions continue to reduce tax collections by approximately 2 to 3 percent of GDP each year. A comparison of the agriculture, manufacturing, and service sectors can help illustrate the extent of these distortions. The agriculture sector, which accounts for 19.2 percent of GDP, pays less than 1 percent of all taxes. The manufacturing sector, on the other hand, contributes 12.79 percent of GDP but 34.5 percent of all taxes, while the service sector contributes 61.68 percent of GDP but just 29.4 percent of tax revenues.

If effective reforms are in place, the tax base widened and compliance improved it is estimated that Pakistan’s tax revenue potential could reach more than 20 percent of GDP, which is considered a realistic level of compliance for lower to middle income countries. This means that the tax authorities are currently able to collect only half of this revenue potential.

An independent study conducted by the World Bank noted that the tax system in Pakistan is complex because of overlapping jurisdictions with different laws, exemptions, and frequent policy changes and lack of any effective reforms thus making the tax administration system both ineffective and limited in its capacity to improve compliance. Based on overall revenue potential, Pakistan’s tax gap today can be estimated to be in excess of 10 percent of the GDP or almost Rs4.6 trillion.

With the present budget, official figures show that from July to May of FY2020- 21, FBR’s tax revenue stood at Rs4,170 billion – 17 percent or Rs621 billion higher against last year’s collection of Rs3,549 billion. It still needs Rs521 billion more to reach the targeted revised tax revenue of Rs4,691 billion for FY2020-21, which it can expect to achieve.

IMF and Pakistan have reached a Staff-Level Agreement under IMF’s Extended Fund Facility which revived Pakistan’s ‘suspended’ IMF program. The plan envisages FBR’s tax collection target of Rs6,000 billion for 2021-22 which would be 24 percent higher as compared to revised Rs4,691 billion (previous target of Rs4,963 billion) for 2020-21 and estimated to be 13 percent of the current GDP. The target seems unlikely to be achieved in view of projected GDP growth at 4.8 percent and inflation at 8 percent and in the absence of any major policy reforms for the widening of the tax base.

In order to achieve these targets the scope and quantum of taxation needs to be widened to those segments from where no or insignificant taxes are generated in order to bring in the required revenue. For example, the share of agriculture and wholesale trade in total direct taxes is around 1.5 percent, although these sectors make up 42 percent in aggregate of the real GDP. Similarly, the exports constitute 10 percent of the GDP but only contribute 1 percent in direct taxes. There is an urgent need to tap the potential of these sources which will not only remove inequities in the current tax regime; but will also provide the much-needed additional revenue to the government. Having said this the present budget does not seem to outline these much necessary measures to tap into the low contributing sectors of the economy.

Pakistan’s larger share of taxes comes from indirect taxes which is contingent with the economic activity and GDP growth. If tax base is not going to increase moving forward, the tax revenues growth may be lower and higher rates of indirect taxes to increase overall collection would only contribute to further inflation.

In the longer term, it is critical for the government to move forward with meaningful reforms which is only possible through effective widening of the tax base through simplifying the existing tax regime. A simpler tax system with standardized tax rates is critical to fostering taxpayer compliance. The focus needs to be on simplifying taxes, procedures, and structures. Curbing exemptions can also reduce the tax system’s complexity while boosting revenue by broadening the tax base.

Successful revenue mobilization needs a more holistic approach towards modernizing tax institutions. Such revenue administration reforms must cover a broad spectrum of legal, technical, and administrative measures. If the Government is serious towards implementing such reforms it would need to undertake both management and governance changes. The organizational culture needs change and modernization with performance based assessment and appraisals and hiring of more competent tax administration officers. The focus has to be on managing information and leveraging the power of big data to improve compliance and fight corruption.

Given the aggressive revenue targets the government must also avoid the usual approach of increase in indirect taxes and withholding targeting the already taxed segment. The focus must be towards widening of the tax base. Tax evasion in certain sectors of the economy must be identified and curbed. A recent study revealed such sectors as auto lubricants, tyres, tobacco industry, real estate sector, pharmaceutical and tea sector as key sectors where evasion is rampant and estimated to be in excess of PKR 300 Bn. Reforms are only effective when such sectors with rampant evasion are identified and curbed and new sources of revenue mobilization generated.

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