The tax gap analysis of the Federal Board of Revenue (FBR) has proposed reduction in the corporate income tax rate from 35 percent to 30 percent, which would improve overall compliance of the corporate sector. Sources told Business Recorder here on Wednesday that the tax gap analysis has recommended several measures to reduce the gap pertaining to corporate income tax.
The main reform proposal is to reduce the standard corporate income tax rate from 35 percent to 30 percent in case of large companies. The loss is revenue will not be substantial, but reduction in tax rate will enhance compliance and the overall revenue effect will be positive.
The report has further proposed the broadening of tax base mainly by rationalising tax incentives and exemptions and lowering the statutory tax rate. Many countries have been able to increase or maintain tax revenues at desirable level through general reform strategy of reducing corporate income tax rates and broadening the tax bases. Another reform issue is about the distortion created by the different treatment to debt and equity.
A range of steps are required to strengthen tax administration. The role of audit needs to be studied and strengthened to have its positive effects on compliance. Higher resources should be provided for audit. The current state of tax returns data leaves much to be desired. The returns are not complete and in most cases do not provide critical information on the basis of which final or withholding tax payments are reported. Out of around 24,000 corporate income tax returns for tax year 2010, only 3,000 had completed depreciation schedules. Tax administration should seek compliance with the corporate income tax form. The financial statements currently required with the returns are filed but are not transferable to the tax return database. This prevents use of another source of information that could be relevant desk reviews or audit.
The report further said Pakistan's individual income tax system requires simplification and rationalisation. The individual income tax is collected through a large number of withholding mechanisms, estimated payments, and final tax return reconciliations, while the laws governing the taxation of different forms of individual income are not integrated. In 2006 there were five primary tax returns that individuals could be required to file, each with different tax rate schedules, depending on the type of income and taxpayer. Besides the complexity of returns and rate schedules, individual income taxation is subject to a large array of exemptions and deductions. Even accounting for revenue receipts is complicated by the use of myriad withholding schemes, and by the lack of classification of receipts from current liabilities, past liabilities, and penalties and interest.
The fundamental direction for reform proposed here is to move toward an integrated individual income tax structure encompassing income of all individuals, including non-incorporated businesses. This entails a radical simplification of the taxation of individual income in Pakistan. The goal behind the integrated individual income tax would be to treat taxpayers, whether they are salaried employees, self-employed businesses, and other non-corporate entities, in a similar way by applying the same tax rate structure to taxable income. Two other reform features should be considered: flat (or flatter) tax rates and dual treatment for capital income. The potential advantages of a flat rate individual income tax have convinced a growing list of countries to adopt this type of reform. Perhaps the most significant attractions for developing countries are the ease of administration and compliance, as well as simplicity in terms of design, for example for inflation adjustments. The empirical evidence on the effects of flat rate income taxes is only emerging but the evidence available for some countries, such as Russia, is that there may be significant positive effects on compliance and smaller effects on real economic activity. There is also the need to recognise the global economic trends that have made an increasing number of countries, in recent times, treat capital income differently from earned income, in what has become known as a "dual income tax" system. Although there are other reasons, the main argument for treating capital income differently is the high mobility of capital in a globalized world.
Sources said that the first reform scenario is the fundamental simplification of the individual income tax through a flat rate of 15 percent. The results of this reform can be simulated using the micro-simulation model using IIT returns for tax year 2010.Unfortunately we do not have data on specific deductions to simulate their effects. However, under various assumptions different scenarios can be simulated. The model also allows for simulation of flatter tax rates with fewer income brackets.
The revenue impact of the two-tier rate system turns out to be fairly similar to the flat rate scenario. The revenue losses from non-withholding and non-capital incomes are reduced, while the revenue gains from withholding and capital incomes are unchanged. Using the MSM, the effects of these changes can be simulated for tax year 2011. The previous study reported that the revenue increases for 2008 were estimated to be Rs 39 billion (34 percent of actual individual income tax collection) under the assumption of current compliance, and Rs 22 billion (19 percent) under the assumption of a drop in compliance of 50 percent compared to the current levels for withholding taxes. The main difference is that individual income tax is now more progressive, although in both cases the tax burden is proportionally larger for the top four population deciles due to the high exempt threshold.
The report said that the reform of the individual income tax could yield higher revenues by adopting higher rates. From the perspective of tax policy design, this modified two-tier tax rate scenario would allow to equalise the highest rate of the individual income tax to the general rate of a reduced corporate profit tax of 30 percent.
In case of Federal Excise Duties, sources said that there is room to expand the role of excise taxes in Pakistan's revenue collection by enhancing their use in addressing certain negative externalities. Rationalising the current rate structure of petroleum products, and increasing excise taxation of petroleum products is in line with these objectives.
A related reform objective is the introduction of "green taxes" on effluents to help curb polluting activities. The revenue impact of such reforms depends primarily on the choice of tax rates. The overriding long term goal for customs duties reform is to spur economic growth through trade facilitation. This agenda includes reducing the tariffs dispersion for different commodities to bring down the effective rates of protections, and to reduce the overall level of tariffs. Tariff reform will also require reducing the number of rates outside the regular tariff bands and eliminating special exemptions. Since custom duties still contribute a sizeable amount to revenue collection, these reforms could have implications for revenue collection. In order to mitigate the risk of revenue shortfalls, custom tariff reform has to be well sequenced with the expansion of the domestic tax base.
The long term reform scenario creates three tariff rates with duty rates of 0 percent for unprocessed goods, 5 percent for intermediate goods, and 10 percent for final goods. Everything else equal, this reform would reduce revenues. However, the proposed decrease in tariff rates is likely to increase the value of imports as lower prices would lead to higher volumes. This would not just increase import duties but also GST collections since GST is applied to the import price inclusive of customs duty; as well as federal excise collections since federal excise duties are applied to the import price inclusive of customs duty and GST. Allowing for these behavioural responses, the net effect of the customs tariff reforms to be a smaller decline in terms of tax revenue.
Sources said that the long term structural tax policy reforms outlined in this section could produce substantial revenue increases. Among the six taxes, the report has identified four revenue gainers and two revenue losers: By far the most important revenue impact would come from GST reform. The adoption of a broad based GST on goods and services in agreement between the federal and provincial governments is therefore the central tax policy reform component. Provincial tax reforms would be the second most important revenue winner.
Introducing a two-tier structure for individual income tax and imposing a 10 percent rate on withholding taxes would raise tax collection substantially. Reforming the federal excise taxation of tobacco would lift tax revenues by another significant increase. The reduction in the corporate income tax rate to 30 percent would reduce tax revenue in the short run. This may be compensated by broadening the base.
The three-tier structure of customs duties would lead to a tax revenue loss but provide economic gains. Pursuing the twin track reforms of tax policy and tax administration would put the government in good stead to meet its medium-term revenue collection target. Tax compliance could increase with a more simplified and uniform tax system, but it could also fall with the overall increase in the tax burden. This makes it so important to complement the reforms of tax policy with the reform of tax administration. Enhancing tax enforcement would contribute to revenue increases through a reduction in the tax gap. GSU estimates, carried out in 2008, suggest that the revenue potential from eliminating the federal tax gap alone (7.2 percent of GDP) was even larger than from implementing the national tax policy reform package (3.8 percent of GDP) - even allowing for the fact that a full elimination of the tax gap is not desirable, since tax administration and tax compliance are costly, report added.