Why the new tax is a good idea

Published: November 15, 2010

And why opposing it means supporting evaders

When it comes to the reformed general sales tax or RGST (since calling it VAT was apparently too provocative) the political parties currently opposing the law would do well to just grin and bear it. The law is brilliant policy and is likely to help the country restore fiscal balance in the long run.

Before explaining the benefits of the new proposed law that has most political parties screaming their opposition in rather unbecoming terms, it would perhaps be useful to disabuse ourselves of this notion that Pakistanis are somehow an overtaxed nation. We are anything but.

Even the most cursory glance at the tax to gross domestic product (GDP) ratio, currently at a miserable nine per cent, will attest to this fact. And while some of the more thoughtful left-wing critics of Pakistani taxation are correct in asserting that the system is at least theoretically regressive, in practice it is not.

Pakistanis are not overtaxed

The most common argument made against the current system is that by stressing the taxation of consumption instead of income, it effectively places a higher tax rate on lower income groups. This is true and especially relevant to the current debate since the RGST is a consumption tax and not an income tax. However, it would perhaps be useful to examine the effect of the existing sales tax on the population.

According to the Household Integrated Economic Survey 2008, conducted by the Federal Bureau of Statistics, the bottom 60 per cent of Pakistanis (by income) spend over 65 per cent of their income on food and housing, two categories of items that are not subject to the general sales tax. In essence, they pay 17 per cent taxes on only 35 per cent of their income, which comes to a 5.95 per cent effective tax rate.

It should also be pointed out that none but the top 20 per cent of households are eligible to pay income tax. So the 5.95 per cent effective sales tax is the only tax that the overwhelming majority of Pakistanis pay. This, of course, assumes that the companies they buy services from do not cheat on their taxes or otherwise fail to comply with the law. Taking non-compliance into account, the effective tax rate goes down even lower.

Having comprehensively refuted the notion that Pakistanis cannot bear the burden of more taxes, it is now possible to argue as to why the RGST is, in fact, nothing short of a brilliant idea.

RGST: setting the tax thieves on each other

The sheer brilliance of the RGST is best understood if it is called by its real name: the value-added-tax. The name says it all – it is a levy on the value added by a firm at each stage of the production process. Unlike the current sales tax, where only the retail level bears the burden of taxation, the VAT’s burden is distributed proportionately throughout the production chain, making it an inherently fairer tax.

But that is not the brilliant part. In order to understand the genius of the system, one must understand the mechanics of it, which is best illustrated by an example.

Let us take car manufacturing, which has several stages of production. In the first stage, a steel mill buys iron ore to make steel. VAT is levied on the difference between the cost of the iron ore and the price at which the mill sells its steel.

However, the way VAT normally works in other countries is that the steel mill pays the VAT on the full price of its product and then applies to the government to get a refund for the cost of its raw materials. The same procedure applies to the next stage, when the car parts manufacturer buys the steel and makes the car parts, paying the tax on the full price of its product and then later applying for a refund. The car manufacturer then does the same thing at the final stage of production.

The above chain illustrates a crucial point: the system relies on two parties reporting the exact same data on the size of their transaction. For instance, the car parts maker reports how much they sold to the car manufacturer, who in turn reports how much they paid the car parts maker. But neither side can collude with the other in tax evasion because what decreases one party’s liability directly increases it for the other. In short, there can be no honour among tax thieves.

The bane of the FBR’s existence

It would also be very easy for the government to determine exactly who is cheating on their taxes. Since there are only two parties involved, the one whose liability would be reduced if the other is telling the truth is most likely to be the tax evader.

Of course, this relies on the entire system being automated, which the FBR has been resisting, partly because several corrupt officials within the FBR extort bribes to help tax evaders get away with their crime, which would become more difficult if the system were put in place.

The system, of course, does not eliminate tax evasion. Of the 29 OECD member countries that implement the tax, The Economist reports that evasion rates range from 4 per cent to 17 per cent.

Yet it certainly makes life difficult for tax evaders, in addition to distributing the tax burden more fairly while at the same time improving the country’s fiscal balance. What is not to like?

The writer is a financial and management consultant based in Karachi.

Published in The Express Tribune, November 15th, 2010.

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Reader Comments (18)

  • Abdullah
    Nov 15, 2010 - 10:30AM

    Please clear me, you mean to say that, when a doctor will be paying VAT to Government, he wont be claiming this from public.
    For example, if currently he is charging 700. And after VAT the fee that he charges to the public will still be charging 700?? or @15% 805.
    Who will pay the VAT the doctor or the consumer. This additional 105 will be paid by public in the form of 805 or the doctor will still charge 700 and pay the VAT from withing this fee as well.

    Who will suffer. The doctor or the public??Recommend

  • Yawar Herekar
    Nov 15, 2010 - 10:30AM

    Brilliant article, Farooq. Helps to explain the RGST a bit more even to the layperson.

    Keep writing. Recommend

  • Ali
    Nov 15, 2010 - 11:02AM

    Your explaining is good, but why don’t we end exemption for income earned from agriculture. That would make it fair. All the exmeptions in Income tax must be done away with now. Everybody who earns enough must pay his due share.Recommend

  • Umair Rehman
    Nov 15, 2010 - 11:09AM

    I can relate to the ideas presented here. No doubt, on paper, thats how the tax would work. But there are some caveats that the author has failed to see.
    1. Once you’ve taxed the input into a value-chain, the authorities can not claim that the price hike would not be passed on. Case in point, food and house rent are exempt, but fertilizer and cement – the inputs for the industries – are taxed. Both are supply-side constrained industries meaning producers have pricing power. Effectively, both of these areas will see inflation, as producers will pass on the tax burden to the end consumer.
    2. Seeing inflationary pressures, consumers, the majority of whom live below the $2 per day income bracket, would adjust consumption. Which means, the portion of consumer spending in the GDP, which is already low, will go further down. Meaning, an economic slowdown.
    3. A hidden form of government tax is inflation. Whenever the rupee depreciates, thats a tax on the buying power of all who spend in rupees. The government is complicit in this crime because it supports deficit spending. Devaluation aids exports, no doubt, but again, for undue benefit to the few, the benefits of the majority are ignored.
    4. Evasion does not vanish from the system because of two-party transaction tracking, because the last party in each industry, i.e. individual consumers, will never be completely documented and will never have the chance to claim sales tax refunds from the government. Remember, a significant portion of the taxes are collected, but not passed on to the government because of limited documentation. If I am a retailer, I have no problem in collecting taxes from the consumers, but I put them in my kitty, instead of passing on to FBR. So, the retailers, who are one-step before the consumer in the value-chain, have an inherent advantage in the fact that only one-side of the transaction will be documented i.e. what they buy, not what they sell.
    Having said that, I would support all measures for broadening the tax net instead of deepening it by taxing those who are already taxed, implementation of agriculture taxes (even though they would raise food prices) because it brings the largest capital class i.e. agricultural land into documentation, higher import duties (for the life of me I can not see why we would like to curtail the consumption of all goods rather than just imports, plus they force an economy to devise ways to make substitutes of imported goods.) VAT or RGST, no matter what the name implies, means vulnerable segments of society would be impacted more and this is not the time to burden them with more monetary troubles than they are already facing.Recommend

  • Jamil
    Nov 15, 2010 - 11:19AM

    Even a starter in economics knows that indirect taxes are regressive. the whole crux of the writer is tax theft of manufacturer but, indirect taxes are paid by end consumer. you can achieve the so called documentation by any rate whether it be 1% or 17% but sadly the real purpose of VAT in Pakistan is Tax collection and not documentation.
    I have analyzed VAT myself on SWOT basis but it is useless and regressive in a developing country like Pakistan but it is really brilliant and genius in developed countries. FBR must be re engineered for effective direct tax collection and once we achieve direct tax collection @ 35% in all 3 stratas of income group and only then VAT must be implemented.Recommend

  • Ahmer Ali
    Nov 15, 2010 - 11:33AM

    Assalam-o-Allaikum Warahmatullah.The new tax is only good for the certified leaders and their army of ministers,advisers and bureaucrats and harmful for middle and lower class related common poor man which is already leading miserable life hardly from hand to mouth.The new taxes shall only increase difficulties and problems in the whole nation’s life.The government should remove corruption from grass-root levels from the departments,increase exports and reduce army of ministers,advisers and bureaucrats instead of thinking and imposing new taxes on the already heavy-taxed and debited poor nation.Recommend

  • Arshad
    Nov 15, 2010 - 12:49PM

    Very Good Idea Tirmizi Sahib! Squeeze More – We’ve still Some Juice Left!

    There are tax evaders but those are the people who are already being heavily taxed. I am NOT supporting tax evasion but just wants to point out that the ones who are NOT AT ALL being TAXED should be TAXED. For God’s sake, LEAVE the poor URBAN society! TAX so called WADERAS, Feudal lords and WAZIRS including the bureaucrats having huge agricultural lands (tax free lands / production), the ones those are still NOT paying a single penny for TAX are those enjoying lives in the villages making huge properties, exclaiming “mein tay Honda le saan”.

    Don’t take me wrong but this is one of the reasons the poor is getting poorer and the rich is getting richer increasing the income inequalities between these societies.

    Elites should be taxed first. If you can’t tax elite then don’t think about imposing such kind of tax reforms. You have committed a SIN. Allah Almighty will ask you about it. Increase TAX net by taxing rich class. You have CRUSHED working-class, the salaried persons residing in the URBAN areas.

    This government is a VERY BIG FAILURE / a COMPLETE example of CORRUPTION – accept it. Its going to be kicked-on-the-back SOON. Wait and Watch…

    PS: I support VAT but this is NOT the time to go for it. I know its an effective way to increase TAX Net BUT FIRST we’ve to impose and implement tax on ELITE which will substantially increase Tax-to-GDP ratio.Recommend

  • m.
    Nov 15, 2010 - 2:12PM

    Farooq,

    I completely agree with Uzair Rehman’s anaylis/rebuttal to your article.

    I also believe that you are mis-using the power of print to play the devil’s advocate and gain cheap publicity for your ill researched article.

    Shame on you!Recommend

  • Danish Munir
    Nov 15, 2010 - 2:39PM

    Dear Farooq,

    A VAT/RGST is regressive as other readers have pointed out. When wealth is so highly concentrated in our country, squeezing out every last bit you can from the ordinary people is going to a) hardly result in any increased revenue and b) going to burden the already crushed people even more. What is honestly needed is a higher taxation of income tax, and most importantly a progressive property tax, based on market-valuations. The proportion of wealth concentrated in the hands of these builders is increasing day by day, while the percentage contribution to taxes is not.

    The 5.9% figure you arrive at for what the impact on the lower/middle classes, the lack of explanation of regressive taxation are further examples of broken logic and lack of attention to detail that is a hall-mark of almost all your writings in this newspaper. Disappointed to see that the volume of what you write is increasing, while the quality is not.

    Sincerely,
    DRecommend

  • Nov 15, 2010 - 3:01PM

    Yes Pakistan may have a lesser tax rate than the rest of the world but pray I would like to clarify how is that justified the new tax on the citiziens struggling to feed their children and committing suicide every day? In other countries, yes the tax rate is much higher but isn’t their slalaires much more higher too? despite paying taxes upto 40% they still manage to enjoy a MUCH better life style than most Pakistanis do. Most Americans/Eurpeans are only happy to pay the taxes even in this recession because they know that ultimtely even if they lose jobs, the governemnt is there to support them so they won’t bne finding shelter or worry about putting the food on the table for their families. Even in this day and age MOST Pakistanis earn about 5-8k/month. Their families either starve on a few days or have 1 meal a day. tt’s no wonder so many are committing suicides each and every day, put yourselves in their place if you truly wish to understand their predicament. If any of us here was earning 8k a month, they would know what it is like paying the rent, feeding their families, paying for school fees, paying for Gas, Electric and Water consumption and other house hold expenses and that is the true situation currently.

    With the imposition of the new tax, it is going to be the end user that is ultimately going to suffer, as it has always been the case here in Pakistan. I fail to understand how this is unavoidable, given the current situation. If a tax is imposed the cost of production to every day life style expenses is going to go up, do you seriously think that these extra expenses along with further price hikes are going to be beared by industrialists? or will the whole salers bear them? Nope, it us consumers who will be paying for it as well always have, as for the “funds” needed for development, I think the popularity for the government shows the state the country is in. So my friend for perhaps for a little better off people like you and me, it might sound like rainbows and butterflys but can we really live in that illusion when people of our country die every day? I think we all know the answer to that.Recommend

  • anonymous
    Nov 15, 2010 - 5:28PM

    Pakistanis pay less taxes… I believe. Pakistani’s have lower per capita income than others..i KNOW!!Recommend

  • Farooq Tirmizi
    Nov 15, 2010 - 7:09PM

    I am a little amazed how most readers seem to miss the fact that I acknowledge that RGST is a regressive tax in the third paragraph. My point simply was that being regressive should not necessarily be a deal breaker. And how have people not noticed that this takes generates revenue not by increasing taxation rates but by making more people pay it.Recommend

  • OA
    Nov 15, 2010 - 9:12PM

    Don’t fully agree with you since there must surely be other ways to expand the tax base, but a well written article nonetheless.Recommend

  • Sara Perriard Noor
    Nov 16, 2010 - 6:16AM

    Finally some sane words! Majority of the people here seem to concur with your input, to much of my surprise it shows people too deny Media reporting that RGST could come as Tsunami, tornado et cetera. FBR will be in a better position to catch tax-evaders once this law is put into effect. The first article I can say I feel I like for its meaningfulness on The Express Tribune, thank you!Recommend

  • Umair Rehman
    Nov 16, 2010 - 10:19AM

    All this uproar to generate 60-65b, when circular debt has already reached 200+. I can see the interest (primarily from IMF and secondly from the govt) to use the time to increase documentation, but as has been pointed out, it could have been achieved by a lower rate. Why the magic number of 15% then? Secondly, I would have preferred a phased approach to implementation, not an all out tsunami – as it is being called by other media outlets.
    On a more contemplative note, I wonder, are we destined to keep choosing between evils, or will we graduate to a position where we get some real choices on the table?Recommend

  • salman haider
    Nov 16, 2010 - 11:53AM

    VAT could bring inflation in our country and the basic commodities would than be unreachable for a person earning 300-350 rupees a day.Our govt instead of bringing our agricultural sector under tax net is going crazy by imposing such a regressive tax.This tax would just destroy our industry which is suffering from power shortage and this tax wont help them at all.Recommend

  • Asfandyar
    Nov 16, 2010 - 5:06PM

    In my opinion, the article highlights some interesting points. However, as the writer has pointed out, under the proposed system each firm in the value chain will have significant amounts stuck in the form of pending tax refunds which, under the current refund mechanism, is similar to trying to locate the missing persons allegedly abducted by the intelligence agencies.
    Frankly, the FBR’s system has a long way to go before it will become fully automated and once it is, only then should RGST be applied. Otherwise many firms with working capital constraints will not be able to survive and investors will also be discouraged from funding these firms.
    Moreover, if implementing RGST is absolutely necessary then why not start with a lower rate, e.g. 5%, at least for those sectors that do not currently come under the GST umbrella.Recommend

  • Umar
    Nov 23, 2010 - 6:49PM

    Great article. Those critics in the comments section don’t seem to have even reads the article. The writer explicitly accept the fact that sales taxes are regressive but goes into a cost-benefit thing.

    If we’re not to slam existing sales taxes but criticize systems that make cheating difficult, I don’t see how that is not downright unethical.Recommend

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