Anatomy of Pakistan’s tax system

Tax system is state extraction mechanism with large efficiency losses, narrow base and minimal compliance

Adam Smith (1723-1790) was a Scottish thinker, known as “The Father of Economics”. His magnum opus, “An Inquiry into the Nature and Causes of the Wealth of Nations”, is the first modern work that treats economics as an academic discipline. He was probably the first person to analyse distribution of resources on the basis of geographical, political, social, economic and technological factors, rather than the decadent and traditional idea of wealth as an outcome of divine distribution. His work on economics of modern taxation is still accepted as the pioneering work on the subject.

In the second chapter of his book, he establishes four cannons of good taxation namely: “I. The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state.… II. The tax which each individual is bound to pay ought to be certain, and not arbitrary. The time of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor, and to every other person.… III.

Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the contributor to pay it.… IV. Every tax ought to be so contrived as both to take out and keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of the state....” These principles now known as i) horizontal and vertical equity (ability to pay and benefits received criteria), ii) clarity, and iii) least distortion to economic efficiency, still remain the cornerstone of every efficient and modern taxation system in the world.

Later on, work of FP Ramsay, James Mirrlees, Michael G Allingham, Agnar Sandmo and Das Gupta developed further insights into the desired policy objectives of tax policy and compliance methods and most of the taxation in OECD countries, and even in neighbouring India, has this sound theoretical basis for their taxation effort. Our tax system, on the other hand, largely remains a state extraction mechanism with large efficiency losses, narrow and shallow base, high degree of horizontal inequity and minimal compliance. Most of the taxes are collected by the mediaeval gate-keeping tax collection method, which collects taxes as the transaction passes through an entry/exit point.

A typical example is the taxation of formal imports which has been contributing 40% to 55% in FBR taxes for the last 10 years. The other major sources are withholding taxes and tax collection from captive large taxpayers in the form of sales and advance taxes. Since these largely compliant sectors don’t want to be thrown out of competition because of lower costs to non-tax paying population (a differential of about 20% in revenues), most of these businesses – especially those having undifferentiated products – have to resort to tax evasion of one sort or the other. Tax officers often wonder why these businessmen require a new amnesty scheme from the government every third year?

It appears that maximum incentive for tax evasion stems from horizontal inequity, where fear of being thrown out of the market compels businesses to understate their revenues. This sort of system re-enforces non-compliance by itself. This divergence from the principles of modern taxation started in the early 1990s and since then we have been reverting to even cruder methods of tax collection which the world last resorted to in the 18th and 19th century (albeit in a physical form, as opposed to the virtual and remote methods available now). There is change in form, not substance. If we look at our income tax, it has major policy gaps in taxation of gains of real estate, agricultural profits, business incomes of socalled, non-profit organisations, and various area/sector exemptions.

Enforcement gaps are even larger where wholesale, retail, services sector, private limited concerns and SMEs grossly under-declare their incomes with impunity, and the FBR is neither equipped nor enabled to assess the correct incomes of any. Looking at sales tax/FED, the collection is exclusively made from imports, large-scale manufacturing, utilities and government purchases. The so-called, value-added tax chain disappears completely after imports and large-scale manufacturing. Both income tax and sales tax laws create an additional cost in the form of high withholding rates from non-filers and further tax on sales to unregistered persons, in a way legalising non-filing and non-registration, by implication. In the form, our tax system has all the fancy attributes of modern taxation, like efilling, audits, value chain taxation, recovery methods, etc, but in essence, it remains devoid of horizontal equity, clarity, low deadweight loss, and ease of compliance.

This different, yet archaic, method of taxation can never take our current tax-to-GDP ratio from 9% to anywhere close to any decent country of our size (the maximum this system can fetch is about 12.5% including provincial revenue) or reduce fiscal deficit which is now equal to FBR’s tax collection effort. Even this meagre tax is being collected at a very high economic cost, as high rates on the formal tax base are not only discouraging foreign investment, but also has the potential of driving the current FDI and formal sector investment out of Pakistan. Horizontal equity, clarity, ease of compliance and reasonable enforcement, all over the world, are achieved by remote monitoring of taxpayer’s behaviours and data-based nudging, with intensive use of information technology, machine learning and artificial intelligence.

Tax offices and tax officers, in the wider world, are fast becoming faceless and nameless. But in this day and age, we are still caught in the legacy of decadent tax structures, procedures and methods. The rest of the world is not much different from us, and so, if we make policy choices which are totally divergent from the rest of the world, our growth, development and financial independence will remain a distant dream only.

THE WRITER IS A CAREER CIVIL SERVANT AND PUBLIC POLICY PRACTITIONER