Pakistan’s taxation regime discourages self-employment and small businesses

Pakistan’s tax policy discourages individuals from self-employment or running small businesses. While salaried individuals get taxed at 35 percent tax only above an annual taxable income of Rs 75 million, self-employed people are taxed at 35% for income above just Rs 6 million. At Rs 6 million, salaried individuals would pay only 22.5% tax on excess income.

If this small business or practice registers as a small company, the tax rate would be 21 percent on the entire taxable income, even as low as 7.5 percent for some SMEs.

Self-employed individuals include professionals like doctors, dentists, lawyers, engineers, accountants, beauticians, fashion designers and tailors, who run their private practices, clinics, beauty salons, boutiques, shops, or businesses as sole proprietorships or partnerships. Self-employed individuals were 15 percent of employed individuals in the EU in 2020, while the World Bank estimates 56 percent of individuals in Pakistan are self-employed. Hence, even without including the workers hired by them, self-employed individuals are vital to our economy.

The provincial governments impose a sales tax of 13-16 percent on revenues from services. Additionally, FBR charges a 7 percent withholding tax (minimum tax) on these revenues. This withholding tax is up to 10 percent for many services. The 7 percent withholding is also charged on the 13-16 percent sales tax. Remember, this isn’t taxing income, but revenues, i.e., the amount the customer pays to the professional for their service. Suppose the yearly revenues are less than what the professional pays his assistants and the expenses for materials, utilities, rent, etc. In this case, the professional won’t make any income that year and would pay for any loss and the 13 percent GST and 7 percent withholding from his personal savings.

As individuals, sole proprietors, associations of persons, etc., we aren’t allowed to pay ourselves a salary (unlike a company). Any profit my consultancy makes, i.e., revenues minus expenses and taxes, is the actual income or salary I get that year.

So, professionals and service providers pay about 20-25 percent tax on the payments they get from clients before paying for other expenses. This 20-25 percent is pretty much an expense we are forced to pay the federal and provincial government, in addition to employee salaries, contractor payments, cost of materials, rent, etc., before we can pay ourselves. It really is not a tax the customer is paying. It is part of the total amount the customer is paying to us, so it directly affects the number of people willing to pay for our service. It is a tax on the service provider, not the customer, no matter what any government organization may try to say.

I remember nearly crying one year when I received Rs 2.5 million for a project but only made Rs 0.5 million profit (income) on it after taxes, salaries, contractors, etc. I paid the federal and provincial government Rs 0.53 million in taxes, more than I earned on the project. I used this income to pay the salaries of my employees till the next project. So, I actually made a loss that tax year, using more of my savings. However, the federal and provincial governments made money on me. My clients paid me Rs 2.5 million, a lot of money. But I have nothing to show for it, although I worked four months on the project without counting the time and effort to acquire it.

Thankfully, FBR has reduced the withholding tax to 3 percent on revenues (plus 3 percent on the 13-16 percent GST) for many services, though not all. That is still a 17-21 percent tax on revenues, making it difficult for service providers to turn a profit, i.e., generate an income.

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Personal income tax rates
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The following tax rates apply where income of the individual from salary exceeds 75% of taxable income:
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Taxable income (PKR)
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Over (column 1)                   Not over         Tax on column 1 (PKR)       Tax on excess (%)
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0                                  600,000                                                     0
600,000                          1,200,000                                                     5
1,200,000                        1,800,000               30,000                               10
1,800,000                        2,500,000               90,000                               15
2,500,000                        3,500,000              195,000                             17.5
3,500,000                        5,000,000              370,000                               20
5,000,000                        8,000,000              670,000                             22.5
8,000,000                       12,000,000            1,345,000                               25
12,000,000                      30,000,000            2,345,000                             27.5
30,000,000                      50,000,000            7,295,000                               30
50,000,000                      75,000,000           13,295,000                             32.5
75,000,000                                           21,420,000                               35
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 (Source: https://taxsummaries.pwc.com/pakistan/individual/taxes-on-personal-income )
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Taxable income (PKR)
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Over (column 1)                    Not over         Tax on column 1 (PKR)      Tax on excess (%)
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0                                   400,000                                                    0
400,000                             600,000                                                    5
600,000                           1,200,000                 10,000                            10
1,200,000                         2,400,000                 70,000                            15
2,400,000                         3,000,000                250,000                            20
3,000,000                         4,000,000                370,000                            25
4,000,000                         6,000,000                620,000                            30
6,000,000                                                1,220,000                            35
================================================================================================

When the small service provider or professional finally starts turning a profit (income), the Pakistan tax regime discourages him from producing a high income (see tables below). No wonder many people hide their income to avoid high taxes. For example, a salaried individual only starts paying taxes above an annual taxable income of Rs 600,000, whereas the self-employed pay taxes above Rs 400,000. A salaried individual pays only 20 percent tax on any taxable income above Rs 3.5 million and under Rs 5 million. But the self-employed pay 30 percent for income above Rs 4 million and under Rs 6 million, and then 35 percent above that. These discrepancies appear in every tax slab.

If you add the 13-16 percent GST paid by these individuals on their revenues, they actually pay 50-70 percent tax, sometimes over 100% (when making a loss), on their actual income.

(Tax on other sources of income, including business, for individuals and association of persons).

You may ask, why not make your business into a company, so you can draw a salary and pay tax at salary rates? Well, do you expect a doctor to set herself up as a company when all she wants to do is see patients? Or a beautician to do that for a salon she runs from home? It isn’t really feasible for most small businesses, which comprise 1-5 people (owner plus employees, if any). Firstly, you don’t know how much income you will make in the first several years. So how do you pay yourself a salary? If you make a loss, will your salary be arrears the “company” accrues indefinitely till the “company” makes a profit? How about the employee salaries and other expenses you pay from your personal savings? Is that Equity/Capital put into the company or debt the company owes you as an individual? Plus, you must maintain separate company and personal bank accounts. “You” can’t take money from the company account, but when the company is out of funds, “you” need to transfer money from your personal account to pay for expenses.

Honestly, it is too confusing for most professionals to think about when all they want to do is their actual work. It also creates an extra load of paperwork and due diligence compared to staying as a sole proprietor, which only requires registration with the FBR and provincial tax authorities. A sole proprietor is already overwhelmed filing monthly sales tax returns, doing the business taxes each year, handling hiring, firing, salary slips, dealing with the banking, printing business cards, handling marketing and sales, the website, the calendar, and loads of other logistical stuff. In addition to the actual work or service the professional is providing. So, registering as a company and adding even more paperwork to this load is not what most professionals, freelancers, or small businesses want to do.

For these doctors, dentists, beauticians, engineers, tailors, lawyers, accountants, mechanics, engineers, programmers, consultants, freelancers, etc., working solo or with a small team, making a company is not the happy solution.

If the government wants to get professionals and small business owners into the tax net, it must ensure that they are not penalized for being self-employed. These individuals are essential to the economy, removing the burden on the government and companies to generate jobs for them to fill. In fact, the self-employed often hire employees. The government should recognize their importance and give them an environment to thrive.

At a minimum, the income tax policy and slab rates for self-employed individuals and income from business must be the same as those for salaried individuals. Once the taxation policies treat self-employed individuals fairly compared to salaried individuals, it will be easier to convince them to register as tax-payers. But an unfair tax policy cannot be compensated by threats or naming and shaming. The unfairness in the system needs to be removed first.

(The writer is an aerospace engineer, an energy efficiency consultant,

and the founder of SaveJoules.com)

Copyright Business Recorder, 2022