Ailing tax system

"The Inland Revenue is here to ensure that everyone understands and receives what they are entitled to and understands and pays what they owe, so that everyone contributes to the UK's needs"-slogan on website of Inland Revenue Service of United Kingdom.
Unlike many other countries of the world, Pakistan's apex revenue authority, Federal Board of Revenue (FBR) has never bothered to launch a well-designed Voluntary Compliance Programme. Resultantly, the number of persons filing income tax returns in Pakistan is pathetically low, though the number of taxpayers subjected to withholding taxes is not less than 50 million. Since 2002, when the new Income Tax Ordinance 2001 was made effective, FBR has miserably failed to implement 'universal self-assessment scheme' by employing modern audit techniques backed by a deterrent in the form of effective Tax Intelligence Systems (TIS). Exploiting the self-assessment scheme, the non-reporting and under-reporting of incomes, evasion of sales tax and federal excise duty is rampant in Pakistan. The government, instead of cracking down on untaxed money, has always adopted the policy of appeasing tax cheats extending generous whitening schemes and tax amnesty schemes.
The failure of FBR is on two counts; firstly it has failed to collect taxes from where these are actually due thus paving the way for an enormous parallel economy and secondly it could not induce the people towards voluntary tax compliance. This has created a malevolent malady - social injustices where the rich are becoming richer and poor the poorer.
The failure to collect assigned targets by FBR for the last many years is widening the burgeoning fiscal deficit - expected to cross Rs 2.5 trillion mark during the current fiscal year. This testifies to the failure of political leadership and economic managers. FBR's fiasco of 'exceeding assigned target' drama in 2011 made a laughing stock of this nation tarnishing whatever little credibility that was left - though not a single person was punished. Policy of giving free hand to inefficient tax officials and appeasing tax evaders, money launderers and plunderers of national wealth is showing its impact in all spheres: political culture of swapping loyalties continues, nation is knee-deep in debt and utter despair - all sectors of economy are showing disturbing indicators. In this scenario, neither political leadership nor technocrats dominating Finance Ministry have any definitive plans for revitalizing the tax system and curing the ailing economy.
The FBR has already conceded its failure to collect revenue of Rs 2381 billion fixed at the time of budget announcement for current fiscal year. FBR has estimated a major reduction in budgetary target of sales tax from Rs 1,076 billion to Rs 945.797 billion and direct taxes from Rs 932 billion to Rs 879 billion. FBR estimates to face shortfall of Rs 1,307 billion in sales tax alone - on domestic stage it has been calculated at Rs 436.692 billion whereas on imports at Rs 509.105 billion. The drastic reductions in sales tax and direct tax targets finalised at the time of budget (2012-13) is going to increase fiscal deficit substantially.
The main reason of low revenue collection in Pakistan is weak fiscal management and policies of appeasement towards tax evaders. We have one of the lowest tax-to-GDP ratios in the world. There is general unwillingness to pay taxes, due to poor public service delivery and because of perceived unfairness in the tax system. To worsen matters, governments keep on displaying conciliatory attitude towards the rich and mighty through various amnesty schemes.
Our real revenue potential is much higher than targets assigned to FBR. For tapping our actual potential, there is an urgent need to make FBR an autonomous body, bring undocumented economy in the tax net, bridge tax gaps and distribute the incidence of various taxes judiciously amongst all segments of society.
The generally accepted principles of taxation are efficiency (explained by reduction in distortions in the allocation of resources), equity (requiring the more able to bear burden of paying tax at higher rates) and effectiveness (insulating tax machinery from all outside influences). These principles are ignored in Pakistan as FBR has become de facto law maker, and its interpreter.
FBR: NEO EAST INDIA COMPANY Our tragedy is that on the one hand we have too many taxes in the country (federal, provincial and local, although the last two only generate negligible revenue for the nation) and on the other benefits do not reach the poor. The few rich are the real beneficiaries of every luxury that is available. Fiscal gap is increasing alarmingly every year. We have utterly failed to reform our tax system, a process initiated as early as the 1990s. The prime reason for this failure is that provinces have not been given any meaningful role in the process and since 1947 our rulers at the Centre have been treating them in the same way as the British imperialists. FBR has emerged as Neo East India Company, its role being fulfilment of the agenda of the rich. It is simply impossible to improve tax administration when tax officers are not accountable before the elected representatives at grassroot level.
FBR distorts data about total number of income taxpayers in the country. They intentionally hide the fact that over 50 million active mobile users are paying 10% income tax, though overwhelming majority does not file tax returns. In the income tax realm, every account holder of a bank, who receives any amount of interest, is subjected to 10% withholding tax. It is worthwhile to note that in their case (except companies) tax deducted at source is full and final discharge under section 169 of the Income Tax Ordinance, 2001. They are merely required to file a simple statement under 115(4) of the Income Tax Ordinance, 2001, if they do not have any other source of income. Had FBR allotted all of them National Tax Numbers (NTNs), we could proudly claim to have nearly 50 million registered taxpayers in Pakistan.
NEED FOR A NEW MODEL Pakistan needs an altogether new tax model, capable of generating sufficient resources for the government and helping the country in paying off its ever increasing debt burden. Taxation, a potent instrument to shape and influence the socio-economic policies of a country, has not received due attention in Pakistan. The foremost objective of a tax policy is raising resources for administration and development, transferring of resources from private to public use. A rational tax policy penalizes those who hold assets idly or indulge in luxury consumption. In democracy, the most important objective of taxation is to provide economic justice, which relates to distribution of tax burden and benefits of public expenditure. Taxation of the rich for the benefit of the poor is at the core of social democracy. It encompasses, besides redistribution of wealth, such questions as treatment of weaker sections of society eg women and children, minorities, the disabled and unemployed. All these elements are missing in our polity and tax policy.
Pakistan is suffering on two major counts: lack of capacity to collect the real potential of taxes and utter wastage of whatever is collected. The tax potential of Pakistan is not less than Rs 8 trillion. However, FBR in fiscal year 2011-12 failed to collect Rs 1,952 billion - shortfall was of Rs 81 billion. It is also showing inability to collect Rs 2,381 billion target fixed for the current fiscal year. It is strange how at the time of budget making this figure was made part of annual income account when it was not "achievable" by FBR. In other words, the Finance Minister resorted to window dressing - falsely portraying that the fiscal deficit would remain in manageable limit.
CHANGE IN TAX ADMINISTRATIVE STRUCTURE The starting point for re-hauling of tax system should be dismantling the existing bureaucratically-controlled structure. FBR should be run by an independent Board of Directors as is the case in many countries. The most recent successful model is that of Mauritius Revenue Authority (MRA). In Mauritius, tax laws are enacted by the Parliament and their implementation is assigned to Board of Directors of MRA that is directly accountable to the Parliamentary Standing Committee on Finance and not the government. Our FBR is run by the headquarters of the ruling political party. Complete insulation of FBR from political influences is a pre-requisite for a meaningful tax reform agenda. An independent Pakistan Revenue Service (PRS) should be run by experts and not bureaucrats having little or defective knowledge of modern tax administration tools.
PARADIGM SHIFT IN TAX POLICY The rich in Pakistan are either outside the tax net or do not pay personal taxes in accordance with their actual ability to pay. As a result, the poor are overburdened with indirect taxes and withholding income tax - 16 percent sales tax on most of the items consumed by them and exorbitant withholdings at source though income is below threshold limit of Rs 400,000. Those who control 90 percent of resources contribute only 2 percent in total tax revenue. Pakistan needs to tax every person having annual income of Rs 500,000 or more at progressive rates irrespective of source of income. This measure alone would generate tax revenue of over Rs 6 trillion provided all exemptions and concessions are abolished.
"The fairness of tax system will be undermined if governments cannot show honest taxpayers that they are making a concerted effort to deal with dishonest taxpayers" - quote from Improving Access to Bank Information for Tax Purposes (OECD 2001).
For generating funds for the poor, the government, through heavy taxation, must discourage certain activities, for example, consumption of luxury goods and tobacco. Such measures act as deterrents, avoiding a spillover of these items in the society, creating disturbance as a consequence. For providing public transport, education, health, housing and improving environment, special surcharges, congestion cess, and carbon tax should be imposed. Value Added Tax (VAT) or Harmonised Sales Tax (HST) on all goods and services is the need of the hour to improve tax-to-GDP ratio significantly.
For achieving the cherished goal of an egalitarian State, we need to take the following steps, using taxation system for influencing allocation of resources:
---- transferring resources from the rich to finance public investment programmes for the benefit of the less privileged;
---- directing private investment into desired channels (rapid industrialisation and value-added service sectors) through heavy taxation of colossal income and wealth accumulated by absentee landlords);
---- increase the level of savings and capital formation by enhancing investment resources for economic development. Recent years have experienced rapid flight of capital, closure of huge industries and economic recession. Lack of consistency in tax policies and perpetual energy crisis have forced business community to move towards safer havens depriving Pakistan of invaluable capital. Similarly, foreign investors hesitate in availing the tremendous Pakistani talent that wastes away for lack of proper funding;
---- promote local industries through the use of import duties, turnover taxes/VAT/HST and excise duties having the effect of transferring demand from imported goods in favour of domestic goods. Fortunately Pakistan has abundant resources and a climate that is fit for any activity throughout the year but due to short-sighted policies of the rulers, onerous tax measures and lack of infrastructure, our industrial sector has detrimentally suffered rendering it incapable of exporting goods to optimal level.
Fiscal decentralisation
Fiscal decentralisation involves the transfer of powers of taxing and spending to sub-national levels of government. Developing countries are in general, more centralised than most industrialised countries were at a similar stage of development. As a consequence of much dissatisfaction with the results of centralised economic planning, reformers have turned to decentralisation to break the clutches of central government and induce broader participation in democratic governance. On an average, for developing countries, the share of public sector expenditure allocated at the sub-national level increased from less than 13 percent in 1980 to about 20 percent in the late 1990s - from 2000 to 2010, this ratio has further improved in many countries, but situation in Pakistan has deteriorated as this figure decreased to below 10 percent.
The existing exploitative, rotten, regressive, ill-directed and unfair tax system is widening the existing divide between the rich and the poor. The sole stress on regressive indirect taxes [even under the garb of income taxation, through presumptive tax regime on goods and services] without evaluating its impact on the economy and the life of poor masses and lack of political will to tax the rich and the mighty is our dilemma-not scarcity of resources or narrow tax base. Equity demands higher taxes from those who have higher income and wealth, but in Pakistan since 1991 all policies have decreased tax burden on the rich increasing its incidence on the poor.
Pakistan witnessed a reverse trend depriving provinces and local governments of generating funds for development and well-being of the less privileged segments of society. Since all broad-based as well as buoyant sources of revenue have been given to the federal government, contribution of provinces in total tax revenues is less than 5% and in overall national revenue base (tax and non-tax revenue) just around 8 percent.
Taxing the poor for the rich!
The people of Pakistan are the most heavily taxed nation in Asia. The privileged classes - ruling the country for the last six decades - are the main culprits who do not pay due personal taxes on their colossal wealth and incomes and are beneficiaries of huge loan write-offs. They are guilty of plundering and wasting public money. The State has become so callous that the people living below the poverty line are also subjected to tax on the purchase of salt, being sold under brand names. People are dying of hunger in camps and elsewhere, abandoning their children at Edhi welfare centres, but the President, Prime Minister, Governors, Chief Ministers, army of ministers, state ministers and their lackeys are wasting millions on their "security", personal comfort, lunches, dinners and visits (domestic and foreign).
A lot can be learnt from other countries' successful experience of fiscal decentralisation. For example, administration of municipalities in Finland, based on self-government, is exercised exclusively by their residents through an elected council. The municipalities have the right to levy municipal tax in accordance with the Local Government Act. This kind of governance is totally missing in Pakistan.
In Finland, extensive functions falling within the specific sphere of municipal authority, eg education, healthcare, residents' recreation and housing, are performed by imposition of municipal taxes. Such an innovation could change Pakistan's fate in a short span of time. We have the resources but the system for self-governance as in vogue in Finland and elsewhere is non-existent. Consequently, power vests with the privileged classes instead of being in the hands of the people, as required under a true democratic system.
Assignment of taxes
The country has been facing an ever-worsening unemployment crisis and a perpetual challenge of rapid industrial growth. But no government has ever thought of 'earmarking of revenue' for 'employment zones'. Such employment zones can cater for:
-- Creation of employment
-- Technological renovations
-- Export promotions
-- Town renovations; and/or
-- Experimentation with new economic management systems.
Pakistan is in dire need of establishing a number of "Employment Zones', which should be low-tax or tax-free for corporate income and for companies creating new jobs. It will be an effective tool to reduce the mounting unemployment burden and to help boost industrial/business growth. The government should identify areas where structural employment is particularly high and then earmark revenue for establishing employment zones in those areas. Out of total collection of taxes at least 25% should be transferred directly to an independent fund for establishment of 'employment zones'.
Revamping tax appellate system
The existing tax justice system - hopelessly outdated, painfully ineffective and marred with inefficiency and inordinate delays - needs complete restructuring so that fiscal disputes between the State and taxpayers get settled within a year at the latest. No agenda of tax reform can succeed unless an effective justice system exists. Present 4-tier tax appellate system is expensive and time consuming. It should be replaced by a 2-tier system - first appeals should go to National Tax Court with intra-court provision and thereafter proceed to Supreme Court directly by way of leave to appeal. This would settle tax disputes expeditiously and restore taxpayers' faith in the tax system
(The writers, tax lawyers and partners of HUZAIMA & IKRAM (Taxand Pakistan), are Adjunct Professors at Lahore University of Management Sciences)