In one of the election rallies, the incoming Prime Minister has rightly observed that tax collection of Pakistan, which ranges to around Rs 4,000 billion in 2018, has to be raised to Rs 8,000 billion to ensure economic sustainability. This is a right and appropriate estimate. Unless we achieve this target, we cannot get out of the domestic debt trap. In the author's view, based on the level of earnings and transactions involved, potential exists to achieve this target. However, the biggest question in order to achieve the said goal is, whether or not this increase in revenue is possible in the short term, within one or two years and is there any short cut route for the same.
In the following paragraphs and further articles on this subject, the author would describe in layman's terms, the history of deterioration in our fiscal structure and the hurdles that are expected to arise in enforcing corrective measures. There is a need for short, medium and long-term policies to achieve the ultimate objective of a sustainable correction. Nevertheless, this analysis reveals that there is no shortcut in this route. The defect is all pervasive and there is a need to trace the history for a complete overview of the present situation. This part is restricted to non-corporate sector only, which represents a large number of people and businesses. They contribute over 40 to 50 percent of commercial activities. Discussion on the corporate sector will be made in the following articles. There will be separate discussion on indirect taxes.
Corrective measures can only be properly analyzed or prescribed when there is full appreciation and proper understanding of the policy errors made in the past that led to the present mess.
History Direct Tax by the name of 'income tax' was levied in India in 1922. Pakistan adopted the law and continued with it until 1979. For 32 years after independence, we carried what we inherited in 1947. India introduced the tax law in 1961.
One of the fundamental features of 1922 Act and its Constitutional framework was that 'direct tax' was inherently applied as an 'urban subject'. Agricultural activities and income therefrom, including rent of agricultural land, was not taxed by the Federal Government. The 1922 Tax Code was essentially a copy of the English Income Tax law. Whether or not society in the sub-continent (from 1922 to 1947) was able to digest that Anglo-Saxon system coherently is a separate debate. In the author's view, it remained an alien law.
One of the main features of that law introduced in 1922 was the supremacy of the 'taxation officer' in the sense that every person was required to be 'assessed'. This was the continuation of the concept laid down in the land revenue system where there is no record of 'produce' and land revenue collector was required to 'assess' the income to determine the government share of revenue. From a practical point of view, each and every taxpayer then called an "Assessee" was required to appear with all books of accounts to be assessed by a tax officer for determination of income for that year. This system in the author's view could not infiltrate within the Indian masses, especially medium and small size businesses and tax collection from that sector, which accounts for a substantial chunk of GDP remained effectively outside the taxation system. In fact, there was never a cohesion between the record keeping prescribed under the law and the manner in which businesses maintained their records. It is still true for whole of sub-continent and even in India, which is marginally more organized than Pakistan. Secondly, as stated earlier, it remained an 'urban' issue therefore trading and businesses in agricultural produce, which is not agriculture income, remained out of taxation system not by way of any law but as custom or practice. In the author's view, they constitute over 20 percent of GDP. Resultantly, a large part of economic activities virtually remained outside the taxation system. For the sake of clarity, rate of tax as an issue will be discussed separately.
In 1979, a new tax code by the name of 'Income Tax Ordinance, 1979' was introduced, which was a copy of the 1922 Act with some adoption from Indian Income Tax Act, 1961.
By the time 1979 Ordinance came into force, it had been clearly appreciated that 'direct tax' system in the country, especially for non-corporate sector, had effectively failed and it did not cater for collection of taxes on all incomes earned which are taxable under the law. Even at that time, 'direct tax collection' could never exceed 6 to 7 percent of GDP. Tax collection on 'net income' basis effectively remained concentrated to large corporations, salaries and banking and insurance sectors. Same is the position at present. This means that the situation after over 70 years is virtually the same.
It is an admitted fact that Income Tax Act, 1922 and Income Tax Ordinance, 1979 miserably failed in achieving the economic objective of equitably taxing all businesses. Part of the failure was 'administration' including corruption, however, the major problem in implementation, like almost all the laws inherited from pre-1947 period, was 'communication' and 'trust' gap between masses and legislation. This gap had been identified way back in 1950 and 1960. However, instead of correcting the fundamental errors, policy makers, led by the bureaucracy, adopted a short-term approach and sought for measures which further spoilt the system instead of correcting it. In the author's view, in addition to communication and trust gap identified earlier, the following five (5) policy errors made over time, consciously, on account of lack of political will destroyed the 'direct tax' policy of the country. All these actions were inherently stop-gap arrangements for collection, having no relation with a tax policy conclusion to local conditions. These measures were:
(i) Inordinate reliance on collection through withholding tax regime;
(ii) Introduction of an inherently incorrect self-assessment scheme;
(iii) Introduction of Final Tax Regime: Presumptive Taxation;
(iv) Treating withholding tax as minimum tax; and
(v) Linking Foreign Exchange Laws with taxation systems.
The negative effects of all these policy measures are so deep rooted that they completely destroyed the linkage between the size of the economy, income in the hand of individuals and direct tax collection. No country can run on such ad-hoc fiscal policy measures. There are substantial economic activities in the market that fall outside the taxation system. The objective of achieving the target of Rs 8,000 billion collection requires all-inclusive participation of all players within the economy.
There was an attempt to overcome some errors by way of introduction of Income Tax Ordinance, 2001, however, on account of weaknesses in policy and administration, the Ordinance introduced in 2001 could not achieve the desired result. It is essential to understand the depth of the effect of these errors if any substantial correction is to be made:
In the Finance Act, 2018 some right steps have been adopted, however, there is a need to understand the real problem with political ownership.
Collection through withholding tax regime
Taxes are to be paid after the income has been earned. During the world wars, UK introduced 'Pay As You Earn' (PAYE) scheme. Under this system, there is a withholding tax at the time of earning which is adjustable/refundable on the determination of income after the year end. This 'war time' measure was also adopted in India in 1922 Act, as it provided regular and easy flow of funds to government. However, this regime was limited to only certain heads of income being 'Salaries' and 'Interest on Securities'. In most of the developed and civilized societies, withholding taxes are only applicable on limited heads of income. Business transactions being import of goods, supply of goods and rendering of services are not subject to any withholding tax.
In 1959 (Finance Act, 1959), Pakistan introduced withholding tax/ collection of tax on supply of goods, rendering of services and import of goods. This provided an easy mechanism for upfront collection of revenue. In reality, the financial objective of collecting revenue were achieved at the altar of economic principle of taxation of income. This provision was introduced by way of Section 18(3BB) of the Income Tax Act, 1922.
This easy way of collection of tax has virtually diluted the spirit and energy of policy and administration within the tax structure for any productive action of identifying untaxed income and taxing it. Resultantly, at present, now almost all kinds of 'receipts' are subject to withholding /collection tax regime and as per a rough estimate around 70 to 80 percent of so called 'direct tax' is collected by way of withholding taxes.
The worst form of advance collection of tax was collection of tax at import stage. A certain percentage of value of import is collected at import stage on account of income or presumed income that will arise on the disposal or use of that imported product.
Extension of withholding / collection tax regime under this easy mode eroded the urge of the taxing authorities to look for meaningful ways to identify untaxed income and tax it at the appropriate rate. This infection, which started in 1959, reached its peak by 2018 and consequently there is no head of receipt/payment where withholding tax is not applied. If there is any comparison of ratio of collection of direct taxes in relation to withholding and collection at source then Pakistan may well be on the top of the list. The first lesson or correction is to relieve the people from withholding tax wherever possible.
The worst effect of withholding/collection regime started with the non-genuine refund of taxes that was not actually collected. It had been widely reported and observed that with the connivance of taxation officer, there were refunds of taxes that were never collected. [This abuse was given as one of the reason for the introduction of presumptive taxation regime].
The worst economic effect of withholding and collection regime was liquidity issues for the taxpayer and other problems for the persons who were exempt from tax, in principle, being exporters and persons where the liability was less than amount withheld.
The intensity of this issue can be judged by the fact that whenever there is any discussion on taxation, the only problem raised by the exporters is the refunds that are stuck up. This is a genuine issue and there is no readymade short cut answer for it. Bulk of corruption on both sides, ie, tax collectors and taxpayers is initiated on account of release of refunds. For the last four to five years, the stuck up refunds of exports ranged between Rs 300 to 500 billion rupees, which amounts to around 7 to 8 percent of tax revenue.
There is a need to completely revamp the withholding tax regime. Tax collection of government cannot rely on withholding regime. Collection would have to depend on filing of returns and taxes paid along with the return on net income. Other negative aspects of withholding/collection regime will be discussed in the following parts.
(To be continued)
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