Reforming taxation for salaried class

Despite being tax compliant, this segment faces high taxes, erosion of benefits

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KARACHI:

The tax system in Pakistan is constitutionally required to be fair, just and equitable. However, a review of the current system reveals a concerning trend: those who are tax compliant are increasingly burdened, while those who avoid the tax net, often by conducting transactions outside the banking system, face little to no consequences.

The salaried class exemplifies this disparity. Despite being among the most tax-compliant segments, regularly filing returns and having taxes withheld at source by employers, they frequently face increased tax rates and the erosion or elimination of available tax benefits.

This unjust treatment is often justified by the government's inability to collect adequate revenue from other sectors due to weak enforcement or political constraints.

As a result, the salaried class becomes the default target for higher taxation. While this may offer short-term relief in revenue collection, it undermines long-term objectives and fuels a culture that incentivises staying outside the tax net.

With the federal budget due within a month, this is an opportune moment to advocate for reforms that support the salaried class, drawing inspiration from international best practices. It's worth noting that the government has projected a 55% increase in revenue collection from the salaried class for the current fiscal year compared to the previous year's collection of Rs368 billion.

This increased reliance on the salaried segment will make it more challenging to introduce equitable and supportive tax measures. However, these challenges can be overcome with political will, sound policy design and robust enforcement. It is concerning that tax laws are often amended under pressure from external lenders, yet domestic reforms that promote fairness across all income groups are rarely prioritised.

First and foremost, the tax rates applicable to the salaried class must be revisited. The current tax-free threshold should be raised from Rs0.6 million to Rs1.2 million per annum.

Moreover, Pakistan rarely indexes its tax brackets to inflation, a globally accepted practice that prevents fiscal drag or bracket creep. Indexing ensures that rising nominal incomes due to inflation do not result in higher effective tax burdens, especially for low and middle-income earners. Far too often, modest salary increments are negated by disproportionate increases in tax liabilities.

Another issue that lies with tax rates of salaried class includes that if a person's annual salary exceeds Rs4.1 million, a flat 35% tax rate applies, down from a previous threshold of Rs6 million, creating a steep cliff effect. There is a clear need to introduce additional tax slabs to avoid such abrupt increases.

Additionally, inconsistencies between income slabs also merit attention. A salary increase from Rs2.2 million to Rs3.2 million results in a marginal tax rate hike of 5.26%, whereas an increase from Rs3.2 million to Rs4.1 million leads to a lesser rise of 3.64%. Such disparities disproportionately impact middle-income earners and highlight the need for comprehensive slab rationalisation.

Unfortunately, Pakistan tends to emulate other countries' tax rate structures without adopting the corresponding tax benefits those countries offer. A recent example is the additional surcharge introduced via the Finance Act 2024, under Section 4AB of the Income Tax Ordinance 2001 (the Ordinance), applicable where the taxable income exceeds Rs10 million. This surcharge is levied even on individuals, including salaried persons and associations of persons (AOPs), and must be reconsidered or withdrawn.

A holistic view reveals that the effective tax rate on salaried individuals often exceeds that paid by small business owners, especially those operating informally or under the minimum tax regime based on turnover.

Salaried taxpayers are not allowed to deduct any personal expenses from their income. A standard deduction, offered in many countries, including India, should be introduced. India currently allows a standard deduction of INR 50,000 under the old tax regime and INR 75,000 under the new regime.

Pakistan could implement a similar deduction without requiring any supporting evidence to cover the basic costs of employment, such as transportation and meals. This deduction could vary depending on the taxpayer's circumstances, with higher deductions for senior citizens, disabled persons, teachers, etc.

Lawmakers in Pakistan could also consider introducing dual tax regimes for salaried individuals. One regime could offer lower tax rates but limit deductions to a standard deduction and a few basic tax credits. The other could allow a broader range of deductions and credits in exchange for slightly higher rates. Taxpayers should be given the option to choose the regime that suits them best.

Other commonly available deductions internationally for salaried class include those for house rent, mortgage interest, life and health insurance premiums and expenses related to supporting dependents with disabilities or chronic illnesses. These costs significantly reduce their disposable income and should be deductible under a fair tax system.

Pakistan currently allows a limited deduction for children's education expenses, but thresholds are too low to be meaningful. These limits should be substantially increased and eligibility should be extended to include the taxpayer's own education and that of other dependents.

Additional incentives could include offering tax credits or benefits to salaried individuals who consistently file their returns on time. The ordinance contains multiple penalties for non-compliance, but very few rewards for voluntary and timely compliance.

A simple tax credit could be granted in the next fiscal year for taxpayers who filed on time during the preceding year. Since most salaried tax is collected through withholding, this measure would not significantly impact revenue but would encourage compliance.

Furthermore, the government could exempt compliant salaried individuals from audits and assessments, except in high-net-worth cases or where specific risk factors are identified. The language of Section 149 of the ordinance should be clarified to clearly outline which claims are permissible when tax is withheld by an employer.

In cases where a salaried person receives refund in a prior year, the refund should either be allowed under Section 149 of the ordinance or processed automatically through a streamlined verification mechanism.

Many additional reforms could help make the taxation of salaried individuals more just, efficient and supportive of broader economic goals. This segment is among the most documented and compliant in the country, yet it continues to bear a disproportionate tax burden due to weak enforcement in other parts of the economy. It is time to prioritise fairness and equity in tax system not just in principle, but in practice.

The writer is a member of the Institute of Chartered Accountants of Pakistan