Sales tax blues

Given rampant sales tax evasion and slowdown in consumer demand, the government is highly unlikely to meet its revenue targets for FY24. This means more government borrowing, higher debt servicing, higher taxes, and an amplification of the current macroeconomic crisis in FY25.

Indirect tax collection, over two-thirds of which comes from sales tax, accounts for between 42.56 and 53.74 percent of government revenue since FY15.

After rising to about 6.7 percent of GDP in FY18, it stagnated around 6 percent and has been on an alarming decline from 6.4 percent of GDP in FY21 to 4.6 percent in FY23 (Figure 1). This is partially driven by a decline in customs duty collection due to varying degrees of import restrictions that have been imposed since FY19. The main determinant, however, is a decline in sales tax collection.

Between FY15 and FY23, GST remained at 17 percent, and federal sales tax collection was resilient at above or close to 4 percent of GDP up to FY21. However, since then it has adopted a downward trend, going from 4.17 percent of GDP in FY21 to 3.78 percent in FY22 and 3.06 percent in FY23.

This is explained by two mechanisms. First, since sales tax is a tax on consumption, a demand shock weighs down on sales tax collection. Second is the incidence of tax avoidance, where sales tax collection decreases despite strong consumption.

Overall, household final consumption expenditure as a percentage of GDP was increasing from FY17 onwards but took a hit in FY20 due to the economic impact of Covid-19.

There was a strong rebound from 80.49 percent of GDP in FY20 to 82.49 percent in FY21 and 84.85 percent in FY22 before a decline to 83.43 percent in FY23 because of poor macroeconomic conditions and hikes in the policy rate. However, changes in sales tax collection are not consistent with trends in consumption (Figure 2).

While a demand shock caused by macroeconomic deterioration and policy rate hikes can partially explain the decline in sales tax collection in FY23, the broader decline in collection since FY21 is indicative of an increase in the incidence of tax evasion.

Anecdotal evidence suggests the same. For instance, many retailers simply do not use the FBR POS, while for others, their credit card machines mysteriously stop working during the second half of the month. Another example is the boom in new apparel being smuggled in as used clothing to avoid payments of import duties and sales tax.

Sales tax evasion is also not limited to the retail sector. In the cotton ginning industry, for instance, gol-maal has become a common practice, whereby production of cotton bales is heavily underreported, and the difference is sold under the table.

However, the main goal here is to avoid paying sales tax on byproducts of cotton seeds that are sold informally but whose sales tax is billed by FBR in proportion to the total production of cotton bales. Similar practices were also recently highlighted in the sugar industry and are prevalent in most sectors.

What does this mean for FY24? The macroeconomic outlook remains poor, and the policy rate can be expected to increase further since inflation is nowhere near subsiding. This will further weigh down on demand and consumption expenditure, which will naturally lower sales tax revenue.

At the same time, tax evasion remains rampant and is likely to increase this year as effective taxation rates, including GST, were increased considerably.

The implications of this go beyond the normal shortfall in government revenue. We have committed a primary fiscal surplus of Rs 401 billion to the IMF.

Total revenue receipts for FY24 are budgeted at 12.16 trillion, of which 3.41 trillion is expected to come from sales tax. If past years are any indication, budget targets are frivolous in any case since they are almost always revised downwards and, even then, go unmet in most years (Figure 3).

Considering the overestimated budget targets, demand-side recession, and increased incidence of tax evasion in tandem, it is highly unlikely that the government will meet its revenue collection targets for FY24. This will mean harsher conditions under the next IMF agreement, more government borrowing which will further add to debt servicing costs, and even more taxes to burden the decreasing share of taxpayers in the next financial year.

Yet there are simple solutions to this. On the retail side, the government must aggressively crack down on tax evasion. The 2022 policy that imposed a fixed income and sales tax on retailers through electricity bills must be revisited, redesigned with a view to widening the tax net, and implemented without remorse.

As of 2022, there were almost 4 million commercial electricity connections in the country, but only about 8,000 retailers integrated with the FBR POS. The remaining can and should be made to pay taxes and become a part of the formal economy.

On the manufacturing side, implementation of the track-and-trace system recently advocated for by the Minister of Commerce has to be a top priority. After the cotton ginning sector, it should be expanded to other sectors where gol-maal is prevalent, and then rapidly rolled out to all sectors of the economy.

Not only will this help clamp down on tax theft in manufacturing sectors, but also promote exports by making supply chains fully transparent and meeting traceability standards of our trading partners. Traceability requirements must also be introduced for high-risk imports, such as used clothing, to clamp down on smuggling.

Given the growing importance of supply chain transparency in global trade, there is a growing threat that without a track and trace system Pakistan will lose its share in key international markets. So, not only will this help achieve the short-term goal of increasing sales tax collection, but also contribute to a sustained increase in exports that is the only permanent solution to Pakistan’s economic woes.

Copyright Business Recorder, 2023