Pakistan

Political Economy of Taxation

Jan 8, 2016
By Sakib Sherani
 
If a second marriage is dubbed a “triumph of hope over experience”, what should an eighth tax amnesty scheme be titled? The government has launched yet another such scheme, its second since 2013, this time designed for the country’s tax-delinquent traders.
 
With an estimated 3.5 million traders in the country, only an estimated 135,000 traders are tax-registered. Wholesale and retail trade accounts for 18pc of official GDP (a reported value addition of Rs4,900 billion in 2014-15), while tax receipts from this segment of the economy amounted to only 1.2pc of total tax collected.
 
In this backdrop, the government took a firm measure last year of introducing a withholding tax on banking transactions of traders who did not file their tax returns (non-filers). This was one of the few genuine reform measures of the current PML-N government, and it appeared for several months that the finance minister and his team would remain resolute. However, with the trading community being a large and important political constituency for PML-N, it was a matter of time before some via media would be evolved to offer an ‘exit’ to the traders. This has now come in the form of the current amnesty scheme, which is a thinly veiled attempt at ‘kicking the can’ down the road to beyond the elections in 2018.
 
While the current amnesty scheme appears to be better designed than previous ones, it is unlikely to taste success in terms of an increase in documentation and tax revenue — for the following reasons:
 
A history of failure: The latest proposed tax amnesty measure adds to the rich history of such schemes in Pakistan since 1958. In addition to the numerous schemes over the years designed to target non-taxpayers, Pakistan has also launched periodic initiatives to ‘whiten’ illegal money and assets via bearer bonds, foreign currency accounts and exemption to foreign inward remittances. The shaky edifice of taxation in the country is completed by other deviations from best practice: the widespread, and growing, use of the withholding tax regime, presumptive taxes, and ‘incentives’ such as exemption from audits by increasing income tax payment by 20 or 25pc each year.
 
The government has preferred to kick the can down the road.
Each of these initiatives was meant to be the ‘silver bullet’ that would magically document the economy, and in a stroke, provide deliverance. However, after over five decades of misguided and self-defeating attempts, the situation on the ground with regards to documentation and taxation remains unchanged, if not having become worse. The undocumented economy is as vibrant and large, if not more, in 2016 as it was when the documentation-via-amnesty route was first adopted. And the country’s tax-GDP ratio has not only stagnated at around 10pc, it has actually declined.
 
The spectacular failure of two similar previous schemes launched by PML-N in 1997 and 2013 is instructive. In 1997, stricter enforcement action by FBR (then CBR) on traders in Lahore resulted in street protests and resistance. After talks with the government, it was agreed that traders would ‘voluntarily’ pay a nominal fixed tax with no threat of audit or further action. The traders in turn, pledging their patriotism, ‘promised’ tax receipts of Rs2bn in a public event with then-prime minister Nawaz Sharif. A year later, the government had received less than Rs150m. This government’s scheme in 2013 met a similar fate.
 
Weak threat of enforcement: The outright failure of the amnesty schemes, barring 1958, should not come as a surprise. Policy lapses aside, FBR’s own pathetic performance can be gauged by the fact that the number of income taxpayers via the filing regime, excluding salaried individuals, is stuck at an abysmal 450,000 (0.24pc of the population). Out of 3.6 million tax-registered individuals and firms, around 900,000 chose to file a tax return (25pc of the total), while only 450,000 showed taxable income (12.5pc of the total).
 
With such low compliance and weak enforcement, there is no credible threat for non-taxpayers of being caught.
 
Moral hazard: In addition to the foregoing, with periodic tax amnesty schemes the order of the day, it is ‘rational’ for a non-taxpayer to wait for the next amnesty scheme — and the one after that — to maximise the amount of time spent outside the tax net.
 
In the presence of lessons from past failures, what should be the correct sequencing of tax reform in Pakistan.
 
Restructure FBR: First and foremost, weaknesses in tax administration have to addressed. FBR has to be made independent legally, operationally as well as financially to insulate it from the political system. Given the rot in the current organisation, an entirely new entity with a new organisational structure and fresh staffing may be the only viable option — as has been successfully done in some other countries (Ehtisham Ahmed and I have separately referred to this as the ‘nuclear’ option).
 
A ban on tax amnesty schemes: Once a new, modern, professional and viable tax administration is in place only then should parliament introduce a law barring any new tax amnesty schemes in the country, offering a final, time-bound scheme valid for three months. Once this period is over, the door on all future amnesty schemes will be closed forever.
 
Closing legal loopholes: In addition to the moral hazard of amnesty schemes, other provisions in the income tax law subvert efforts at enforcement by tax authorities. These include provisions such as exemption from income tax and audit to funds received via foreign remittances [Section 111(4)], and other provisions such as paying 20pc higher income tax than the previous year etc.
 
The sensible and pragmatic recommendations of the Tax Reforms Commission and FBR in this regard should be implemented.
 
Only by viewing tax reform in a holistic manner and via a systems approach that recognises the interconnectedness of the country’s tax system with the rest of the economy, can a meaningful effort be made at improving tax enforcement and compliance.
 
The writer is a former economic adviser to government, and currently heads a macroeconomic consultancy based in Islamabad.
 
Dawn, January 8, 2016

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