Why the new tax is a good idea

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 15^th, 2010.