Thursday July 18, 2024

Tax dilemma: choose long-term reform over short-term fixes

It is no longer acceptable for the small formal economy to bear the disproportionate tax burden for the whole country

By Ghias Khan
May 29, 2024
Representational image of a tax return form. — APP File
Representational image of a tax return form. — APP File

(Former president, OICCI)

POLICYMAKERS in Pakistan face two broad choices when it comes to proposing revenue measures in the Finance Bill for 2024-25.

As the country stands at an inflection point, one option is to resort to stop-gap measures to meet the tax revenue target: increase the taxes on the already taxed. However, this may provide short-term relief but will not yield positive results in the long term.

The social contract in Pakistan is at a breaking point. It is no longer acceptable for the small formal economy to bear the disproportionate tax burden for the whole country. They are voting with their feet, by finding employment and investment opportunities abroad, signalling dissatisfaction.

On the other hand, if the right reform mindset is acquired, and consistent tax reforms are carried out over multiple budgets, it can create national corporate champions like the Tatas and Ambanis of India. This presents a viable way out of the economic morass that the country finds itself in.

For the economic transformation of our country, the federal government needs to focus on four key areas: i) tax reforms; ii) energy sector reforms; iii) formulation of sector-specific industrial policies to encourage investments; and iv) privatisation of SOEs.

If the government makes meaningful progress in each of these areas over its five-year term, it will have accomplished its economic goals and laid the foundation for sustained growth. In this article, I focus on the first area -- meaningful tax reforms -- as the government prepares to present the Finance Bill for the year 2024-25 in the coming days.

This year’s budget provides the government with an opportunity to demonstrate its commitment to structural reforms to both domestic and foreign investors. The government is walking a tightrope by having to please multiple constituencies, whose interests are often conflicting. Rather than seeking radical, overnight changes, this budget should aim to be ‘directionally correct’, keeping in view that the economic transformation of our country will require multiple budgetary cycles.

Instead of focusing on what tax measures are most needed, it might be useful to apply the principle of inversion and identify what will not work in terms of tax reforms. Increasing the tax burden on the formal sector, whether on corporations or individuals, is clearly not going to work. The relatively small formal sector in Pakistan already bears the bulk of the country’s tax burden, paying income tax, corporate tax and many indirect taxes.

In contrast, the informal sector indulges in widespread tax evasion, with estimates indicating that it constitutes approximately 70 per cent of Pakistan’s economy. Not only does the informal sector avoid taxes, but the unfair tax advantage also hinders the formal sector from achieving their desired scale in operations.

However, it is becoming increasingly clear that growing the share of the formal economy is possibly the only credible way to sustainably enhance Pakistan’s low tax-to-GDP ratio. If the size of the formal economy vis-a-vis the informal one can be enhanced, it will allow for significant growth in tax revenues in Pakistan. A larger formal corporate sector will pay more indirect taxes (input taxes) and direct taxes (corporate tax and income tax) as it scales up its profitability and employs more individuals.

For the formal sector in a country to flourish, four major factors need to be assessed: 1) transportation; 2) communication; 3) digital-led financialization; and 4) meaningful tax reforms. In India, tailwinds from these factors enabled the creation of national-level companies in the formal sector, allowing them to dominate and capture market share from informal and regional players. As a result, the share of the formal economy in India has steadily risen over the last three decades, from a modest 35 per cent in 1992 to 56 per cent by 2022.

Although India’s population is approximately six times that of Pakistan and its economy is eleven times larger, the scale of its corporate sector far exceeds Pakistan’s, even when adjusted for population and GDP differentials. Some comparisons are particularly telling: the revenue multiples of India versus Pakistan in terms of the top three banks is thirty-one times, the top three conglomerates is thirty-seven times, the top three auto companies is forty-eight times, and the top three IT companies is three hundred and twenty times.

In Pakistan, the first three prerequisites for the formalization of the economy (improvement in transportation, communication and digital-led financialization) are either in place or are progressing well. However, meaningful tax reforms are missing. Tax reforms, in terms of both direct and indirect taxes, need to be steady and consistent, with a focus on better enforceability, compliance, and collections. Once these tax reforms make tax evasion difficult, the proportion of the informal (and usually tax-evading) sector will decline.

For this, a change in the government’s thinking and approach is required. Having a non-filer category is counterproductive; it suggests that non-compliance is acceptable as long as the higher tax rates on asset purchases are factored into the cost of doing business. This mindset among policymakers has perpetuated a culture of tax evasion and non-compliance in the country.

The long-term goal to improve the formalisation of the economy from the perspective of tax reforms is to make large asset purchases with cash extremely difficult, if not impossible. Purchases of assets like houses and cars should be made through the banking system, and not in cash. This requires an increase in official real-estate DC rates to bring them closer to market values and enforcement at auto distributorships. However, a step-wise approach may be more prudent than dramatic overnight changes, which are likely to face opposition and potentially be reversed. As mentioned earlier, the key is to be directionally correct, not radical per se.

In this budget, there are three concrete steps the government can take relating to tax reforms to encourage the formalisation of the economy. First, it should clamp down on smuggling (smuggling allows the cash economy to thrive). Second, it should enforce the purchase of large assets like real estate and cars exclusively through banking transactions by registered taxpayers. Third, it should roll out a digitisation initiative in the retail sector and allow seamless data sharing to the Federal Board of Revenue by banks and NADRA.

Moving forward, more ambitious tax reforms should also be considered. For instance, India implemented a country-wide unified GST in 2016 and pursued demonetization, both of which were disruptive in the short term but have now yielded results in terms of improving the formalisation of their economy. Consequently, India’s tax-to-GDP ratios have increased significantly.

Pakistan needs to find relevant and practical solutions given its socio-economic context. However, policymakers must maintain consistency in their approach and not lose sight of the underlying objective: increase the share of the formal economy, which in turn improves tax collection in the country.