A special study on sugar sector has suggested increase in the rate of Federal Excise Duty (FED) in Value Added Tax (VAT) mode on sugar from 8 to 12.5 percent, as the sales tax paid by the sugar sector in 2013-14 is Rs 10.352 billion, which is only 34 percent of the net sales tax liability of the sector in 2012-13. It is learnt on Saturday that the study on sugar sector has been conducted by Lahore University of Management Sciences (LUMS) and submitted to the Federal Board of Revenue (FBR) for a necessary action.
The estimates show that exemptions on input tax come to Rs 4.088 billion while net sales tax liability of the sugar mills @8 percent tax comes to Rs 38.26 billion. And allowing for zero rated export of sugar in 2012-13, the sales tax liability reduces to Rs 30.426 billion. In other words, the average sales tax liability of each sugar mill comes to Rs 0.28 million per annum. The sale tax paid by the sugar sector in 2013-14 is Rs 10.352 billion, which is only 34 percent of the net sales tax liability of the sector in 2012-13.
The study has find that the current rate of Federal Excise Duty (FED) in Value Added Tax (VAT) model of 8 percent of value in the sugar sector is below the optimum tax rate. The simulations suggest that the optimal tax rate on sugar is 12.2 percent. In other words, increasing tax rate to 12.2 percent would maximise tax revenue. The tax collection at this rate is projected to be 13 percent higher than the current tax collection.
The focus of the study is on the manufacture of sugar, classified at the 4-digit level by the Pakistan Standard Industrial Classification (PSIC) 2010 as PSIC 1072, it said. It is predicted the effects of changes in output tax rates on sales tax revenue in the sugar sector. The study used the partial equilibrium analysis to estimate market demand elasticity of sugar, elasticity of sugar supply and the relationship between tax rate and tax evasion. We use this information to predict tax revenue changes that may result from changing the tax rate.
It has been found that the current rate of Federal Excise Duty (FED) in Value Added Tax (VAT) mode of 8 percent of value in the sugar sector is below the optimum tax rate. The simulations suggest that the optimal tax rate on sugar is 12.2 percent. In other words, increasing tax rate to 12.2 percent would maximise tax revenue. The tax collection at this rate is projected to be 13 percent higher than the current tax collection. These results are robust to alternative sales tax rates and tax evasion rates. For instance, while the estimates for optimal tax rate are slightly different for different assumptions regarding the relationship between tax evasion and tax rates, the baseline result that the current tax rate is lower than it should be to maximise tax revenue collection is robust to all these assumptions.
It is concluded that these simulations on the relationship between tax evasion and tax rate can be improved further if real time data is shared with us by the FBR on tax collection under various tax rates since 1991. This exercise would result in more precise estimate for the optimal tax rate.
While, Evaluating the Size of Income Tax Evasion, it said that our estimates of the potential income tax collection for the sugar sector show that total profit of the sugar sector is Rs 43.541 billion and the average profit made by each firm is Rs 613 million. However, there is considerable variation in the profits across firms. The lowest profit made by any firm is just Rs 6 million. Whereas the highest estimated profit is around Rs 2.786 billion for firm no.3.
Based on our results of earlier sections, we suspect that firms grossly misreport their earning by underreporting their production value. In this way, they end up paying less income tax than they should. We did not have access to data on income tax collection from the sugar sector so we were not able to compare our estimated numbers with the actual revenue collected. We also do not have information on the fraction of output that is exported by each firm. If this data is made available, we will be able to come up with much more precise numbers for each firm, it said.
The purpose of the study is to evaluate the effective rates of input-output ratios, measure sales tax compliance and evasion by benchmarking input-output ratios, predict the effects of potential changes in the sates tax rates on tax revenue also known as tax Laffer curve, evaluate income tax liability on the sugar sector by estimating the size of profits made by each firm and document details of processes of production used in the sugar sector to gain better understanding of the operating cycle. The main findings of the study along with recommendations stemming from the analysis are given below.
It said that an effective sales tax audit requires that disaggregated input-output (1/0) ratios are known to the tax officials. We conduct this exercise to calculate the effective rates of 1/0 ratios by taking data from the Census of Manufacturing Industries (CMI) 2005-06 and verify it with an econometric model applied to the annual balance-sheet data of 41 sugar mills from 1999 to 2007. The validity of the calculated 1/0 ratios were verified from the technical staff of some of the sugar mills. Factor inputs on which sales tax exemptions are claimed by the sugar manufacturing sector was particularly focused in this exercise.
The study findings suggested that the sugar manufacturing firms use 10 inputs in the production process. Raw material (ie, sugarcane, sugar beet and raw sugar) has the largest share at 70 percent, followed by user cost of plant & machinery at 12 percent, labour cost at 5 percent, user cost of capital at 2.5 percent and spare parts at 2.3 percent. The rest 8 percent share goes to packing material, purchased electricity, fuel, chemicals, lubricants and fuel. The second approach used to verify these shares was based on the balance-sheet data, but factor inputs were not available in that much detail as in the CMI data. Based on three factor inputs, our econometric results suggest that the average share of raw material in sugar manufacturing is 73.6 percent, which is not far from the CMI results. The consultations with industry experts, particularly those who are directly involved in the production process in sugar mills, have independently confirmed that the share of raw material (sugarcane) in sugar manufacturing is around 70 percent.
While sugar manufacturing sector is the second largest sector in Pakistan's economy, there are concerns about low tax collection rate from this sector amidst suspicion of misreporting of inputs and outputs by some of the sugar mills. Therefore, a benchmarking exercise is critical for the sugar sector to identify the best performing firms and to compare them with others. in this regard, we use an econometric framework that is particularly relevant to conduct this exercise widely known as the stochastic frontier approach (SFA) in the economics literature. In this approach, firm inputs and outputs are taken to benchmark firms. Firms who operate on the best practice frontier are regarded as most efficient since they convert inputs into outputs most efficiently, while others are termed as inefficient.
The analysis is based on firm level data on factor inputs and outputs reported by the firms in the CMI 2005-06. There were 71 sugar mills who reported this information and this information was used to estimate the model. The names of firms are not disclosed in the CMI data. However, we used multiple techniques to match firm names and were able to match 65 of the 71 sugar mills.
To estimate the stochastic frontier model, we used the gross value of production as output variable, and ten input variables namely, plant, capital, labour, raw material, spare parts, fuel, electricity, packing material, lubricants and chemicals. Our results suggest that random error in sugar industry is roughly equal to zero and the huge majority of production variation is explained by firm-specific inefficiency, which may be attributed to vast misreporting of inputs and underreporting of the outputs by the sugar mills.
It has been found that, the sugar manufacturing sector faces increasing returns to scale since the sum of all input elasticities is 1.15. A 10 percent increase in the value of inputs leads to 11.5 percent increase in the value of the sugar produced. In other words, cost of sugar production would decrease if the scale of production is increased. However, if a large segment of the industry is found to under-report production, then this result would be misleading.
Contrary to the evidence of effective 1/0 shares reported above, our benchmarking exercise suggests that most sugar mills misreport their factor inputs. For example, if these firms are to be believed, then packing material, labour, lubricants and spare parts are the most important inputs in sugar production and raw material (ie, sugarcane, sugar, beet, raw sugar) has very low share. For example, the share of packing material (73 percent) is too large and the share of raw material (5 percent) is hugely small. We also detect over-reporting of chemicals where the empirical results suggest that a 100 percent decline in chemical use would increase sugar production by around 16 percent. These results are false, which simply contradict the firms' principles of profit maximisation.
To further investigate this matter, we conducted an experiment where we separated the data of 21 best performing sugar mills from the total sample and re- ran the regressions. And in sharp contrast to the results of full sample, input shares of the selected sugar mills closely matched with the effective 1/0 shares reported above. Therefore, we use our 1/0 shares in the subsequent calculations.
We find that average misreporting of factor inputs by the sugar mills is 27.3 percent. Our benchmarking exercise further suggests that firms who depart from the best practice frontier are the ones who are vastly misreporting their inputs and outputs. The production misreporting varies from 0 percent in firm no.65, 64 and 63 to 93 percent in firm no.1, which is hard to believe. Therefore, we recommend that a thorough audit of firm 1 is conducted. Other sugar mills where high misreporting of production is taking place include 88.5 percent in firm 2, 65 percent in firm 3 and 64 percent in firm 4. Our estimates show that production misreporting of 29 worst performing firms exceeds the average misreporting (27.31 percent) for the whole industry. And these firms are equally spread out in Punjab and Sindh provinces.
Our benchmarking exercise also leads us to estimate the value of production of each sugar mill, which in turn is used to calculate the sales tax liability of each firm in 2012-13, aggregate production of the sugar sector and the overall tax liability after exemptions on input tax already paid. Using the proportion of production of each firm in 2005-06, the quantum index for 2012-13 and adjusting for misreporting of production, our estimates suggest that sugar sector produced Rs 529.362 billion worth of sugar in 2012-13, which is 44 percent higher than sugar production reported by the sugar industry in 2013-14, it added.
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