The gains from GST

One of the principal reasons for the low tax-to-GDP ratio of Pakistan, which stands at just 10 per cent, is the under-taxation of over 70 per cent of the economy, consisting of the agriculture and services sectors, which contribute less than 30 per cent to tax revenues. Any sensible tax reform, therefore, would attempt to spread the tax burden more evenly in the economy by reducing taxes on industry and raising them elsewhere in the economy.

The objective of the move towards a broad-based VAT, now known as the reformed GST, is precisely to accomplish this. The reform will lead to a standard rate of 15 per cent, down from 17 per cent, and reduce the burden on existing taxpayers, primarily from manufacturing.

Simultaneously, some of the exemptions for certain goods in the GST Act, 1990 will be withdrawn and the tax net will be extended to services by legislation through the provincial assemblies.

What are the implications of this reform? First, given the failure to effectively tax agricultural incomes, the withdrawal of GST exemption on agricultural inputs will partly fill this gap. Second, the inclusion of most services, with the exception of education and health, will lead to a very large expansion of the tax base. Since the share in consumption of services by the rich is much higher, this will also imply a more progressive tax system in Pakistan.

In the first stage of the reform, given the problems of limited documentation of the economy and poor tax collection, those with an annual turnover of less than Rs7.5 million are exempt from paying the reformed GST. This is two to three times the threshold in countries like India, Sri Lanka and Bangladesh. Estimates are that the number of new taxpayers will not exceed 110,000 and almost 97 per cent of retail outlets will be exempt. The intent here is not to tax the corner grocery shop but the departmental stores enjoying economies of scale and catering to the demands of upper-income households.

Which services will contribute more to revenues? Telecommunications is the biggest service which is currently taxed and contributes over Rs60 billion to the exchequer. A range of corporate entities will now also become taxable.

The reformed GST has the potential to significantly increase the revenue stream of the country. First, withdrawal of some of the current exemptions on goods could yield an additional Rs35 billion or so. Second, extension of the tax net to comprehensively cover services, which account for more than half of the economy, will depend upon the extent to which the tax base is eroded by the presence of the threshold level and how much of the revenue will be reduced by tax invoicing of services as inputs. Estimates by the Revenue Advisory Council of the Federal Board of Revenue are that, after allowing for these factors, the reformed GST on services could eventually yield net additional revenue of about Rs250 billion, equivalent to 1.5 per cent of the GDP.

Ideally, the reformed GST should be collected by one entity so that integration of goods and services is achieved. But if the provinces, like Sindh, wish to exercise their legitimate right to collect the sales tax on services themselves then the pragmatic approach may be to go for single-stage taxation rather than in the VAT mode, probably at a lower rate initially.

The bottom line is that the imperative is to broaden the tax base to cover under-taxed sectors and not to get bogged down in issues of who collects and in what manner.

Published in The Express Tribune, August 6^th, 2010.