Improving tax compliance

The caretaker government has set up a tax reforms taskforce to come up with recommendations to close the ‘tax gap’ due to weak compliance, without requiring any additional tax policy measures. This is the appropriate approach as the caretaker government does not have the power to change the existing tax laws.

The first estimate of lost revenues due to weak compliance by the FBR is very large at Rs 2.7 trillion in 2023-24. This is equivalent to 2.5% of the GDP. In other words, tax evasion and weak compliance have implied a loss of revenues equivalent to almost 30% of actual revenue. This is apparently FBR’s own estimate and reflects poorly on the quality of its own tax administration.

The FBR estimates are that the biggest loss as a percentage of actual revenues is in the sales tax of 50%, followed by 36% in income tax and much less at 15% in excise duty and customs duty. This is surprising. The general perception is that tax evasion is the highest and compliance the lowest in the income tax.

An initial indicator of level of compliance is the number of returns filed. As of January 2, 2023, the FBR’s website showed a total of 3,925,497 persons on the Active Income Tax Payers list (ALT). This is equivalent to only 8% of the number of employed outside the agricultural sector of Pakistan. Agricultural incomes are exempt from the federal income tax.

A comparison can also be made with the number of taxpayers who filed income tax returns in India. The number is 74 million, almost nineteen times the number who filed returns in Pakistan. The economy of India is eight times the size of Pakistan and with employment outside agriculture of 300 million; the rate of filing of returns by employed population is almost 25%. This is over three times the rate of filing of returns in Pakistan. It is not surprising that the tax to GDP ratio in India is as high as 17% of the GDP, substantially above that of Pakistan.

The low rate of filing of returns in Pakistan is surprising given the extremely elaborate withholding tax regime in the income tax system. There are almost 70 deductions at source and the withholding tax rate is double the normal rate on persons who are not on the Active Tax Payers List. Surely this ought to have increased the pressure to file returns.

The other issue is how much tax evasion is FBR able to identify through the process of auditing annually of a random sample of returns and by other mechanisms of detecting non-filing of returns. The total revenue generated from this process by FBR was Rs 101 billion in 2021-22. This is only 10% of the loss of revenues apparently due to low compliance. Clearly, there are leakages and inadequacies also in the audit process.

Which are the sectors which are likely to be characterized by low levels of income tax compliance? These are sectors where there are more informal transactions and higher proportion of small entities engaged in production or distribution. As such, small-scale manufacturing, wholesale and retail trade, transport and private services are likely to be more prone to lower levels of tax compliance.

The taskforce ought to focus on mechanisms for increasing revenues from these sectors by reducing the quantum of non-or-under reporting and tax evasion. This may require further broadening and deepening of the withholding tax regime. However, changes in sections of the Income Tax Ordinance relating to withholding taxes will also be required to be included in the Finance Act in a mini-budget or annual budget, which is beyond the constitutional powers granted to caretaker governments. However, innovative and effective administrative and process- related proposals may be identified by the taskforce for early implementation.

Turning to indirect taxes, the media has reported that almost Rs 1.4 trillion is estimated by the FBR as the revenue loss due to low compliance in these taxes, especially the sales tax. This is an inordinately large magnitude. If the estimate is, more or less, valid then this again highlights the failure of the FBR to limit the quantum of tax evasion. Hopefully, the taskforce will come up with ingenious proposals for digitalization of transactions, development of more elaborate track and trace systems, etc.

This is a need to highlight the necessity for raising the level of revenues from provincial taxes through higher compliance, with no changes in tax rates. Perhaps the best example is that of the urban immoveable property tax. Today, this tax fetches only Rs 30 billion in the four provinces combined.

The primary reason for the considerable under-exploitation of the revenue potential of the property tax is the greatly outdated assessments by the Provincial Excise and Taxation Departments of the Gross Annual Rental Values (GARVs) of properties for determination of the tax liability.

A comprehensive updating of the GARVs as an administrative measure could lead to a quantum jump is property tax revenues and enhance the financial resources especially of the large Metropolitan Corporations in the country.

In conclusion, it must be recognized that the caretaker government has taken the appropriate step of constituting a taskforce to identify mechanisms for raising the level of tax compliance. The time has also come for a comprehensive set of reforms to make the tax system of Pakistan markedly more progressive. This will facilitate the successor elected government in implementing expeditiously a strong agenda of tax reforms and use thereby the substantial additional revenues for providing major relief to the much larger population of the poor in Pakistan today.

Copyright Business Recorder, 2023