Sales tax collection on services: World Bank suggests reforms for devising mechanism between FBR, provinces

The World Bank (WB) has suggested comprehensive reforms for devising an effective mechanism between the Federal Board of Revenue (FBR) and provinces for collection of sales tax on services. According to the World Bank (WB) 'Pakistan Tax Policy Report,' four options have been given to the federal government as well as provinces for proper sales tax collection on services.
A comprehensive reform of the sales tax on services could take several directions, ranging from decentralisation to centralisation. The incremental solution is to expand the base by bringing more services into the tax net. This extension should begin by including those services that could most easily be reached under current administrative practice.
However, continuing with the present system does not address the disconnect between who administers the tax and who gets the revenue. Nor does it allow a province to easily ratchet up collections if it should choose to do so. The likely result is that there would not be much revenue enhancement under this reform option, especially if this proposal is not accompanied by a national incentive package to stimulate or reward provincial governments for increasing revenue efforts. If the incentive strategy was successful, Punjab and Sindh, with their more developed service sectors, would likely emerge as revenue gainers, the WB said.
The second option is to transfer the ten services that are presently taxed by the federal government to the provinces, and make provinces in charge of sales tax collection on services. Assuming a similar revenue effort as today, this would increase provincial revenues from the service tax by a factor of more than seven -assuming the provinces administer the tax as well as FBR. The next step would be for the provinces to begin expanding their tax base selectively by bringing the easier to reach services into tax. The revenue yield from this option depends on how quickly the provinces learn sales tax administration, and how quickly additional services are brought into the tax net. Nevertheless, this approach has a number of drawbacks.
First disadvantage is that the "easier to tax" services with a broad base are likely to come away with a much heavier tax burden than other services. Second, the proper accounting for cross-province sales of inputs would be particularly difficult for the province tax authorities given their limited experience with the sales tax.
Third, the federal government would almost certainly resist surrendering this taxing power, in particular if it might reduce the domestic resource mobilisation compared to the current system. Finally, as discussed below, most importantly, moving tax administration from federal to provincial level might incur revenue losses due to the weaker administrative capacity at the provincial level.
The WB said that the third reform option is to convert the sales tax on services to a shared tax with the federal level. The federal and provincial governments would tax the same services, with assessment and collection carried out by the federal government. There would be a separate federal and provincial government tax rate (not to exceed 16 percent).
The services to be taxed would have to be the same under such a regime, and the federal rate would be the same in all provinces. The provincial tax rate could vary according to the decision of the provincial government. This autonomy in provincial rate setting would preserve an important fiscal decentralisation feature, even though it could introduce some administrative complication.
There might be restrictions here, eg the federal rate might be set at 8 percent and the provincial rate would be limited to 8 percent. This approach combines the rate setting discretion of provincial governments with the superior administration capacity of the federal government. One drawback is that it could accentuate the headquarters problem. Particularly, Sindh could follow a strategy of taxing services heavily and exporting its tax burden to other provinces.
The fourth option is to fold the sales tax on services into the federal general sales tax on goods and services and share the revenue gains between federal and provincial governments. This is the preferred tax reform option, as it would deliver the largest revenue gains, while also bolstering the efficiency and equity of the national tax system.
The revenue sharing could be resolved in different ways. In particular, the tax revenues from services could be handled in the same manner as from goods. The federal collections on goods are part of the NFC revenue sharing pool, of which currently 43.5 percent accrue to the provinces. This outcome could also be achieved by taxing services through federal excise duties in VAT mode.
But of course, a different revenue sharing formula could be agreed in view of the potential increase in the revenue base. By comparison with the present system, the province would do better in terms of revenues. At the same time, the federal government would have a greater incentive to collect this tax than under the current system, as over half of the receipts would accrue to the centre.
The federal tax administration could also exploit synergies in the sales taxes on goods and services to strengthen overall GST collection. With both provinces and the federal government gaining revenues, this could be a win-win situation. The main drawback of this approach from the provincial point of view is that provinces give up the formal exclusive claim on services as provincial tax base, the WB added.