We seem to have no understanding of what ails our taxation system — III

Introduction

This is the third part of a series of articles on the subject ‘We seem to have no understanding of what ails our taxation system’. Like the preamble to Part I of this three-article series of articles I never wanted to write something unpleasant about the taxation system of Pakistan that exists since 1951 when sales tax on ‘goods’ was introduced by the federal government – a complete politicization of a fiscal matter at the cost of the wellbeing of common people of Pakistan. However, when I realized that things are going out of control and unnecessary smoke screens are being placed to hide certain facts from people I decided to present my own perspective. This is a completely different viewpoint and is in line with my initial assertion that there is something seriously wrong which needs to be rectified with a view to correcting the socio-economic order of the country. I know that my statement will be deciphered in a political sense; however, I still believe that politics and economics cannot be totally separated. The ultimate objective is the overall wellbeing of the people and steps towards a welfare state. As against my desire I start with the reproduction of a synopsis of the Indian Budget for the year 2021-2022 which is presented on April 1, 2021. Both India and Pakistan are products of the same umbilical cord therefore it is better to see what they are doing and what we can learn from each other.

Synopsis of Indian Budget 2021-2022

As Finance Minister Nirmala Sitharaman presents the Union Budget 2021 in the Parliament on Monday, a pertinent question is where this comes from and where it goes. According to Budget 2021, the total receipt for FY21-22 stands at Rs 34,832 billion which includes revenue receipts and capital receipts. The revised estimates for total receipts for FY20-21 stands at Rs 34,503 billion.

Taking a look at the avenues from where the money comes from. According to the Budget 2021, the major contributor is borrowing and other liabilities - 36 percent, goods and service tax - 15 percent, income tax - 14 percent, corporation tax - 13 percent, union excise duties - 8 percent, non-tax revenue - 6 percent, non-debt capital receipt - 5 percent and customs - 3 percent.

When compared with the current financial year, borrowing and other liabilities contribute 20 percent, corporation tax - 18 percent, goods and service tax - 18 percent, income tax - 17 percent, non-tax revenue - 10 percent, union excise duties - 7 percent, non-debt capital receipt - 6 percent and customs - 4 percent.

Now is the turn for expenditure. The government plans to spend Rs Rs 34,832 billion in the next financial year with a revenue deficit of Rs 15,068 billion according to the Budget 2021. In the current financial year, the revised estimates show an expenditure of Rs 34,503 billion with a revenue deficit of 18,486 billion.

The interest payments will get the maximum portion, 20 percent, followed by states’ share of taxes and duties - 16 percent, central sector scheme - 13 percent, finance commission and other transfers - 10 percent, other expenditure - 10 percent, subsidies - 9 percent, centrally sponsored schemes - 10 percent, defence 8 percent, pension 5 percent.

In the current financial year, the division was — states’ share of taxes and duties - 20 percent, interest payments - 18 percent, central sector scheme - 13 percent, other expenditure - 10 percent, finance commission and other transfers - 10 percent, centrally sponsored schemes - 9 percent, defence 8 percent, subsidies - 6 percent, pensions - 6 percent.

Analysis of Major Differences

This represents only the Union Budget. In India, unlike Pakistan, provinces (states) in general generate around 75 % of their resources. If the total tax collection of Union India’s is added to the total tax collection of tax-to-GDP soars to around 18% as against less than 12% of Pakistan, by the same token. Be that as it may, the point under discussion is not the overall tax to GDP ratio. The point in question is distributional equity and manner in which and sources from where such taxes are collected.

Furthermore, in India Corporation Tax is identified separately from non-corporation income tax. It is the author’s view that this is also the requirement under Pakistan’s constitution. In India, like any other country, a very substantial part of collection is made from taxes on income not indirect taxes and taxes on corporations. In Pakistan, through a primary policy error taxes on income have been reduced to a very low level and are not separately disclosed as required under the constitution of the country.

From the revenue side, very important and pertinent factors to identify are the sources of revenue for the Union (Federal Government). These are:

1. Over 30 percent of revenue of the Indian Union Government is the interest received on Loans granted by it to various Provincial Governments. This subject would have to be understood properly. The cash requirements of the provinces over and above their share under the NFC are to be met by the Union by way of loans from the Union and at present around 30% of the revenue of the Union Government is interest on such loans. The result of the system is that in India the central government is rich and States that are responsible for spending on welfare are also held to account for the money they spend. In other words, there is an inherent federalism built in the system. In Pakistan, however, the system has worked in exactly the reverse order. This, however, is a different subject that will be taken up in another article on the structural changes in financial management of Pakistan;

2. Unlike Pakistan, Indian provincial (state) governments are not as poor and overly reliant on the Centre. These states have their own revenue systems and reasonably well established expenditure side. Almost every state the revenue generation is over and above 75% of the total resources. The main source of provincial or state revenue is provincial excise duty on production and sales tax on consumption of goods (inter-provincial sales tax has now been brought to the Centre). The gist of the argument is that in almost all the states of India, revenues generated by provinces finance over 60 percent of the total expenditure. In Pakistan, however, all the provinces are totally dependent on the Federation through the National Finance Commission Award (NFC). This raises the question whether Pakistan’s system is working like a Federation in the sense it was originally conceived. The issue started getting worse when all the sources of taxation, the major ones being excise and sales tax on goods were transferred from the provinces to the Federation in 1951. Since then the ideals of Federalism in Pakistan in relation to fiscal management are questionable. The solution for the same in general has been discussed in the following paragraphs:

3. The third major difference is the composition of Corporation Tax and Taxes on Income. At present, the collection of taxes on corporations and taxes of collection on the non-corporate sector are disclosed separately. At present, the non-corporate taxes on income are exceeding taxes on corporations and in the Budget 2021-2022 the amount to be collected. In the year 2021-2022 taxes on income which are all income based amount to Rs 5,610 billion being the whole collection of taxes in Pakistan. The most important part of this analysis is that not even 1% of the same is presumptive taxes. The whole amount is assessed on self-paid tax based on income. Until and unless Pakistan comes closer to this reality there cannot be any sustainable achievement on the taxation side.

Is it a legislative Issue?

The secondary question that arises out of an unseemly comparison with India is to identify whether or not our mismanagement is the result of any legislative error we have made or otherwise. This aspect has been highlighted by creating a comparison in the Constitution of both the countries.

In the following paragraphs I have reproduced the right of taxation of the Federal and or Union Governments in Pakistan and India. If the said schedule / lists are examined then it transpires that both the constitutions largely derive their strengths and weaknesses from Government of India Act, 1935. However a major change which Indians have made and we are still struggling to make is regarding VAT, Sales Tax or Consumption Tax which is the major source of revenue in the present setup.

Pakistan’s Federal Legislative List provides the right to the Federation to tax the following. Only relevant items have been listed:

1. Duties of customs, including export duties.

2. Duties of exercise, including duties on salt, but not including duties on alcoholic liquors, opium and other narcotics.

3. Taxes on income other than agricultural income;

4. Taxes on corporations.

5. Taxes on the sales and purchases of goods imported, exported, produced, manufactured or consumed, except sales tax on services.

6. Taxes on the capital value of the assets, not including taxes on immovable property.

7. Taxes on mineral oil, natural gas and minerals for use in generation of nuclear energy.

8. Taxes and duties on the production capacity of any plant, machinery, undertaking, establishment or installation in lieu of any one or more of them.

9. Terminal taxes on goods or passengers carried by railway, sea or air; taxes on their fares and freights.

10. Fees in respect of any of the matters in this Part, but not including fees taken in any court.

Indians are not much different from Pakistanis and their Seventh Schedule to the Indian Constitution provides the following rights to the Union with respect to taxation:

1. Taxes on income other than agricultural income.

2. Duties of customs including export duties.

3. Duties of excise on the following goods manufactured or produced in India, namely:—

(a) petroleum crude; (b) high speed diesel; (c) motor spirit (commonly known as petrol); (d) natural gas; (e) aviation turbine fuel; and (f) tobacco and tobacco products

1. Corporation tax.

2. Taxes on the capital value of the assets, exclusive of agricultural land, of individuals and companies; taxes on the capital of companies.

3. Estate duty in respect of property other than agricultural land.

4. Duties in respect of succession to property other than agricultural land.

5. Terminal taxes on goods or passengers, carried by railway, sea or air; taxes on railway fares and freights.

6. Taxes other than stamp duties on transactions in stock exchanges and futures markets.

7. Rates of stamp duty in respect of bills of exchange, cheques, promissory notes, bills of lading, letters of credit, policies of insurance, transfer of shares, debentures, proxies and receipts.

8. Taxes on the sale or purchase of newspapers and on advertisements published therein. (omitted as per 101st Amendment Act)

92A. Taxes on the sale or purchase of goods other than newspapers, where such sale or purchase takes place in the course of inter-State trade or commerce.

92B. Taxes on the consignment of goods (whether the consignment is to the person making it or to any other person), where such consignment takes place in the course of inter-State trade or commerce.

92C. Taxes on services. (omitted as per 101st Amendment Act)

Criterion Under the NFC Award

It will be interesting to briefly touch upon the distributional system of Federal Taxes in India and Pakistan. Initially, both were same; however, there has been serious evolution of a distributional system which we call National Finance Commission (NFC). Distributional equity with sustainable growth cannot be achieved unless there is an equitable NFC Award and there is a constant nonpolitical effort to improve the same. Independence and transparency of NFC is the backbone of any sustainable growth. The summary criterion used in the latest Indian NFC will reflect briefly the context of the subject being discussed.

The purpose of reproducing the same is not to provide any ideal situation. The only purpose is to identify that there are reasonable examples in the comparative situation and Pakistan has to work constructively to achieve the desired result of tax to GDP of plus 15 percent as soon as possible. Provinces would have to carry the Federation, and not vice versa.

Where we have lost the track?

The analysis reveals that the main difference lies in the case of VAT. India struggled with VAT for the last 10 to 15 years and they are now moving to a Federal VAT however that is only with respect to inter-state transactions. India has however not made the following mistakes with respect to VAT, Sales Tax or Consumption Tax:

• Unlike Pakistan in whatever shape, transactions remain within the orbit of the state’s radar. There is very low level of unrecorded production and sales as compared to Pakistan;

• India has not messed up the VAT and Sales Tax System with collection at import stage and converting it into presumptive VAT;

• India, unlike Pakistan, is not deepening or sharpening differences in relation to the supply of goods; it is now rendering of services and moving towards a combined VAT.

In summary, it can be stated that in India the transactions are in Government record and its each state has the writ to tax production, sales and consumption. It is only the decision about the manner of taxation that is in question. As against that, Pakistan has a very correct VAT law in theory (except collection at import stage); however, it is an undeniable fact that almost 50 percent of the persons who should have registered with the taxation system are out of registration. For example, there are over 350,000 industrial and commercial gases and electricity consumers, who should have been registered under the sales tax. They, however, remain outside the tax system. That is why the number of registered persons is around 70,000 to 80,000 only. In other words, it can be easily concluded that Pakistan has to do a lot to massively revamp the existing taxation system. India could be used as an ideal example to emulate to achieve the desired results as it is widely believed that despite animosity, shared cultural heritage holds India and Pakistan together.

Why there is no direct income in Pakistan

The state of affairs of domestic tax collection is worse than the import sector. The table below which has also been reproduced in Part I of this series of articles has been analyzed further to identify the head under which taxes on domestic level are being collected and their effects and impacts on the overall system of taxation. In short, the things are not desirable. There is, therefore, a serious need to completely change the whole paradigm.

As is apparent from the table below there are two elements in the domestic collection. These are collections at import stage (which has been discussed at length in Part I and Part II) the second part is withholding other than at import stage. A proper analysis and discussion will reveal the manner in which the taxation system has been completely spoiled in the country. The issue under consideration is not the steps being taken for correction. At the first stage the matter to be settled or discussed is to identify the ground realities.

The primary question in Pakistan is to remove the misperception about the fact with regard to people who are paying and those who are not paying taxes. As will be discussed in the following paragraphs there are over 75 heads under which withholding is made however over 90 percent is collected from 16 heads. This may be the first time such analysis has been made in detail. Therefore, as a first step there is an immediate need to remove nearly 60 heads of withholding from the law. This will provide a relief to the taxpayer and time and energy to the tax department to concentrate on collection of tax on net income basis.

The second task is to identify out of the aforesaid heads the amounts collected which are determined on presumptive basis being indirect taxes, in all sense but disguised as direct taxes to the stakeholders. Each and every item is discussed in the following paragraphs:

Salary: This is one of the heads where tax withheld is not under the presumptive basis. However, on account of the prevalent presumptive taxation system where deduction of expenses has become irrelevant payment of salaries on record is killing the system. For example, when an exporter is not bothered about salary expenditure as there is no deduction for expenses there is no incentive to pay salaries on record and charge tax accordingly. Furthermore, the strange character ‘contract executed’ with a lower rate is an easy means to avoid/evade tax under this head. The solution is a reduction in the tax rate with simplification in the system;

Dividend: In almost all the countries in the world there is no tax on dividends. There is always a withholding tax adjustable against final tax on a net income basis. There is no tax on dividends on inter-corporate cases in any ‘civilized’ society. In Pakistan, in almost all the cases it is a presumptive tax at the rate of 15 percent which discourages corporatization and payment of dividend. Personal dividends at the option of the taxpayer are to be taxed on a net income basis after taking into account the cost of investment. No presumption for income.

Interest: A major junk of this tax is the presumptive tax withheld at source on interest credited on bank accounts on deposits at the rate of 10 percent. This tax is also a presumptive tax and there is no record from where the amount of deposit was received, the expenses against that, etc. This presumptive tax be converted into final tax at the full rate after allowing expenses under the law. At present, the position is that in Pakistan a person can keep as much money as he likes in bank account without any question and get discharged from any other query as long as presumptive tax equal to 10 percent of income is paid. The question is whether or not the purpose of presumptive tax is to hide the source or have a lower rate. I am convinced that the purpose is to provide a state-sponsored tax haven for money and the source of which need not be explained.

Supply of Goods/Rendering of Services/Contracts Executed: Considering taxes withheld at source on supply of goods, withholding of services and contracts executed as the presumptive taxes without any imputed tax is the biggest intellectual tax crime committed in this country. Unfortunately, without realizing the full facts, the Supreme Court of Pakistan in the Elahi Cotton Mills Limited case validated the same as income tax. Until and unless this major aberration in the taxation law in Pakistan is removed no significant increase can be made in the revenue collection in Pakistan. This law means that if there is a supply of goods by any person then the amount of tax withheld at source say at 5% is the full and final ‘income’ liability under the constitution. As highlighted in my first article I can accept everything except that this amount is a direct tax. If it is so then I wonder how the Supreme Court of Pakistan can qualify the same as ‘Taxes on Income’ under the constitution. At the moment I am not concerned with the decision of the apex court. The question is whether as a nation we are ready to continue the same as a matter of commercial expediency.

Exports: Presumptive taxation on exports is also an apparent aberration. Exports should be zero rated and there should not be any tax on income earned from exports. However, those exports should not only include exports of goods but also exports of services. The present system of taxation on exports is totally unproductive and leads to complete non-documentation in this sector.

Electricity & Telephone Consumption: These are two interesting heads of withholding. Both are adjustable, for obvious reasons. During my tenure as Chairman FBR the President of a traders’ body of a big city informed me that he had given instructions to his tax consultant that his net income tax liability should be 5 to 10 percent higher than the amount he was charged as withholding taxes on electricity bills. As can be seen above the amount of collection on electricity bills is increasing with a corresponding increase in tax collection from that sector. This system is worse than presumptive taxation and demonstrates the fact that as a country we have totally failed in collection of taxes on a net income basis.

This summary analysis of collection as withholding taxes on domestic level was made to demonstrate that it is totally wrong to assume that there is any concept of taxes on net income basis except for companies in Pakistan. The system has been well engineered that there is perpetuation of wealth within a certain class without any checks or balances on them. They are all legally protected. The purpose of writing these three articles was only to identify that it is wrongly presumed that certain administrative changes without going through a complete overhaul of the system will result in any meaningful change in the system. When I was the Chairman FBR I tried to convert a lot of presumptive taxes into minimum taxes with the sole purpose that taxes in principle should not provide a shield against unexplainable sources of wealth. In the present circumstances, the following are my suggestions in this particular regard:

1. Remove all withholding taxes which are over 50 in number where collection is even less than Rs 5 billion in the whole year in the whole country;

2. Minimum tax be introduced instead of presumptive taxes; and

3. Exports be zero-rate, including exports of services; and

4. A new social order is designed for taxation of VAT in line with Indian’s experience.

This concludes the series ‘We seem to have no understanding of what ails our taxation system.’ The only purpose of this series of articles was to demonstrate that there has been a disastrous downfall in our capabilities in tax administration; however, the policy measures which we adopted to overcome the gap were so flawed and so incorrect that they have virtually killed the concept of taxes on income in Pakistan. It is a fact that no civilized country, without any major natural resources, can survive with proper taxes on income. Taxes on consumption can be borne by the society to an extent and that ceiling has already been achieved. Whatever may be the political results, this government or the next government would have to swallow the bitter bill of taking drastic steps aimed at improving direct taxes on income. This will be against the paradigm we have been witnessing for the last thirty plus years. It is quite unfortunate that smoke screens are being intentionally created for the government by certain powerful vested interests to divert its attention away from real tax issues.

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Table 1: Criteria for devolution (2020-21)
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Criteria                        14th FC        15th FC
                                2015-20        2020-21
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Income Distance                    50.0           45.0
Population 1971                    17.5              -
Population 2011                    10.0           15.0
Area                               15.0           15.0
Forest Cover                        7.5              -
Forest and Ecology                    -           10.0
Demographic Performance               -           12.5
Tax Effort                            -            2.5
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Total                               100            100
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Copyright Business Recorder, 2021