Tax exemption for IT export employees is dangerous, will hurt Pakistan

The Pakistan IT Industry Association (P@SHA)is asking the government for a tax exemption for IT export sector employees. They’re using the argument that tax exemption given to freelancers is being abused by remote workers and this is creating an uneven playing field between remote workers and employees of the IT export corporate sector and is therefore hurting the corporate sector.

The problem identified here is correct and we do need to create a level playing field. But offering tax exemption for IT export sector employees is dangerous because it will create more problems than fixing them. Let me explain why.

Background: the remote worker problem

In 2021, the government gave a blanket tax exemption for freelancers through a 1% “final tax”.

But, without a clear definition of a freelancer in the tax code, this started getting abused by remote workers who in turn started hurting the IT export corporate sector.

Freelancers are individuals who take small jobs from multiple clients in a year. They find work through various freelancing marketplaces like Upwork, Fiverr, FlexJobs, or personal contacts. Their annual income is always less than $10,000.

Tax exemption given to these “true” freelancers does not hurt the IT export corporate sector.

Remote workers are full-time employees (with full benefits like onsite employees) of foreign businesses that do not have any physical office in Pakistan. Remote workers are working from home in Pakistan. They’re usually senior seasoned professionals making between $20,000 to $100,000 a year in salary tax-free (1% final tax).

On top of this, they’re being paid the same rate that the IT export corporate sector businesses get paid when work is outsourced to them.

As a result, remote workers are being paid 3 times their local counterparts working for IT export businesses and doing the same work.

The net effect of all this is that many mid-level and senior employees of the IT export corporate sector who have been painstakingly groomed over many years are leaving in droves to join foreign employers as remote workers.

The corporate sector is unable to retain them and is therefore becoming less competitive globally. Pakistan is already a brain-drain country and this was hurting the IT export corporate sector, and now this remote worker problem has exacerbated the situation even further.

At the same time, employees not leaving to become remote workers put undue pressure on employers for huge salary raises because remote workers make so much tax-free. So, just in a short span of 1-2 years, most IT export sector salaries were more than doubled.

This has increased the cost of doing business which has made the IT export sector less competitive globally because other countries do not have a remote worker problem.

So, we must fix this imbalance between remote workers and the employees of the IT export corporate sector if Pakistan’s IT exports are to grow.

Tax exemption for IT export employees is dangerous

Tax exemption by nature creates an imbalance among taxpayers and creates an unnatural and rapid move toward this incentive by taxpayers from other sectors. That is why it must be specifically targeted to a small well-defined group so it does not hurt other important sectors of the economy.

We must also learn from other countries like India, Bangladesh, Vietnam, and the Philippines that are much more successful in their IT exports than Pakistan.

Interestingly, no other country offers a tax exemption for individuals. Tax exemption is only offered to targeted businesses. The reason is simple. Businesses create employment, train employees into seasoned professionals, build global brands, and develop intellectual properties like Apple, Google, and Microsoft have done.

In 2021, the tax exemption for freelancers (individuals) was offered without proper targeting and we have seen its unintended consequences in the shape of the remote worker problem.

This happened even though targeting freelancers for tax exemption was easy because they are very different from remote workers but we did not do it.

However, there is no such difference between remote workers and local employees of the corporate IT export sector businesses. That is why a brain drain started occurring from the senior members of the corporate IT export sector toward becoming remote workers.

In the same manner, no such difference exists between local employees of the IT export sector and the domestic IT sector. So, if tax exemption is now offered to the employees of the IT export sector, it will badly hurt the domestic IT sector in the same manner.

Then, next year the government will be pressured to give tax exemption for the employees of the domestic IT sector. If that is done, then we’ll see other sectors close to the IT sector getting hurt.

So, as you can see, offering tax exemption for IT export employees is a slippery slope that will lead to a chain reaction resulting in undesirable ends and hurting our economy.

The solution: tax exemption only for freelancers and IT export businesses

We must not fix the remote worker problem by giving even more tax exemptionsfora new set of individuals (IT export sector employees) because of its negative impactas explained above.

Instead, we should kill this problem at its root,fix what was done wrongly in 2021,prevent the remote workers from abusing the tax exemption given to the freelancers, and require them to pay taxeslike regular employees of the IT sector.

The solution is very simple and easy to implement and is also aligned with the international best practices.

1. Fix the freelancer definition in the tax code and offer tax exemption only to freelancers and not all individuals. A freelancer is defined as “an individual taxpayer who must have 2 or more clients in a year to qualify, and if qualified then he gets tax exemption for up to a maximum of $10,000 a year of income”.

2. Offer tax exemption only to IT export businesses. Tax exemption must be offered only to IT export businesses owned by individuals or AOPs with 5+ employees (EOBI registered), or owned by companies (public or private limited).

This will result in remote workers being taxed like regular employees and create a level playing field for the IT export corporate sector.

Myth: remote workers will park money overseas if taxed

This is a common fear that drives the decision-making of our policy makers who are unfortunately not very well informed on this subject.

The reality is that according to the State Bank of Pakistan data, almost 85-90% of our IT exports (including remote worker income) come from countries like the US, UK, Western Europe, Australia, Japan, Singapore, etc.

In other words, our IT exports come from very advanced economies that have well-defined taxation systems with very strict monitoring and controls over international transactions. These countries also have tax rates the same or higher than Pakistan.

Since our FBR is very weak in such matters, people assume the same about all other countries.

On top of this, the foreign employers who hire remote workers are usually larger companies if they can afford to pay $20,000 to $100,000 a year of salaries.

Such companies always follow the law and will not allow remote workers to get paid through proxy or in another tax haven country either because of their own tax rules or if FBR simply documents and publishes a rule that 100% of remote worker salary must be sent to Pakistan since it is taxed.

Additionally, all payments made to remote workers are through banking channels so at any time when FBR builds the capacity, it can easily audit and catch the small number of culprits who park money in tax haven countries.

So, in reality, it is very difficult for remote workers to keep money abroad. They cannot park it in a tax haven country. And, if they keep it in the first world countries, they get taxes so there is no incentive for it. Besides, countries like India and Bangladesh have the same tax evasion culture as Pakistan. But they tax their IT professionals on foreign income without any known problems.

Myth: IT export employees will leave the country if taxed

This argument makes absolutely no sense. All the evidence says that IT professionals move abroad because they find much better opportunities and earn a lot more money overseas, and even more importantly in the case of the first world countries they also have a path to citizenship for themselves and their families. Tax is never a consideration in their decision.

That is why, the Middle East despite being a tax haven is not their first choice but the last one.

Anybody who does not move abroad does so because of his personal/family reasons or because he is not qualified enough to find a good job overseas.

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