Minimise exemptions and special treatment of individuals and economic activity

September 6, 2015

Dr Ijaz Nabi explains what is right and wrong with the taxation system of Pakistan

Minimise exemptions and special treatment of individuals and economic activity

The News on Sunday: Let’s begin at the beginning. Why does the state want to tax its citizens and how has the Pakistani state suffered in the absence of revenue from taxes.

Dr Ijaz Nabi: Taxation to pay for services citizens need is one of the most critical functions of the state and goes to the heart of the social contract that defines the relationship between a modern state and its citizens. The state is especially mandated to provide certain public goods (such as security and law and order, a system of justice, defence, foreign policy, national communication infrastructure, public health, redistributive programmes, etc.) that citizens either cannot provide themselves or they can only do so after prohibitive levels of cost and coordination. These public goods are financed out of tax revenue.

The state would collapse in the absence of essential services. To avoid that, we incur expenses on essential services even in the absence of adequate revenue. This can lead to public debt, i.e, expensive debt-servicing and/or inflation, both of which are taxes but in forms that can be harmful to economic development objectives.

TNS: Apparently, the citizens have no faith in the moral authority of the state. Is that the only reason why they don’t pay taxes and how can this situation be rectified?

IN: Only terrorists and those who want to overthrow the state see no moral authority in it. Citizens certainly have political differences with incumbent governments but this does not imply a rejection of the state of Pakistan. Citizens don’t pay taxes because they can get away with not paying them, as the state is too weak, unwilling or unable to enforce its will.

The low tax collection stems from a variety of inherent structural weaknesses in the taxation system including: (i) a policy regime that excludes important segments of the economy/population from the tax net (agriculture, retail trade, many property owners, specific individuals and economic activity, etc), (ii) an inefficient tax administration (poor management, weak human resources, lack of adequate IT supporting systems, excessive scope for discretion and rent seeking behaviour), both of which lead to (iii) a narrow tax base (of 39.4 million employed persons, less than 10 per cent are registered and active taxpayers. (Source: Hamid Mukhtar CDPR 2015).

TNS: Looking at the raison d’etre of taxation system in Pakistan, there seems to have been a shift towards regressive taxation, instead of progressive taxation. Is this a true assessment?

IN: There is little evidence to support the contention that taxation in Pakistan is regressive. The problem is not regressive taxation but horizontal inequity -- individuals with the same income are treated differently.

The government should focus on taxing consumption as is done in the rest of the world. Consumption taxes can be designed in a manner that their burden does not fall on the poor.

Minimise exemptions and special treatment of individuals/economic activity. Bring about horizontal equity among tax payers. Have credible audits. Put the full authority of the state behind FBR. Improve service delivery.

Despite the fact that only a tiny fraction of the Pakistanis pay their taxes, we do not actually have high tax rates. The effective total tax rate in 2011 (including income tax, sales tax, and excise duty on goods) for an average rickshaw driver was about 4 per cent of his income. For an average fresh university graduate working in a company, the effective total tax rate was around 6 per cent; for a manager-level professional, it was about 17 per cent and for a senior executive it was about 27 per cent. The tax system is unfair not because any single individual’s taxes are too high, but because far too many wealthy individuals are not subject to taxes at all. (Source: IGC and CDPR 2012)

TNS: Of the three ways to reform taxation system, one is reform of the FBR. Can you suggest briefly the areas where we need this reform?

IN: FBR can only be as strong as the government makes it. The government has to fully back the FBR in achieving its mandate. FBR has strong data systems which can be utilised very efficiently. It does not, however, have strong human resource capacity, which the government has to invest in building.

Researchers working on taxation now believe that reforms related to tax administration are as important as tax policy reforms, especially in developing countries where administrative capacity is too weak to fully implement any tax policy. Thus, there is now focus on improving the administrative capacity of tax authorities to enforce policies.

Recent research done by the International Growth Centre (IGC) researchers on property tax in Punjab shows that monetary incentives to inspectors increased tax collection without causing inaccuracy of assessment or taxpayer dissatisfaction. Incentives don’t have to be only monetary in nature. Non-monetary incentives (promotion and transfers) can also be quite effective. (Source: Asim Khwaja IGC and CERP 2014)

TNS: The FBR constituted a tax reforms commission in September 2014. What is its mandate and how will it help?

IN: I do not have any information on the tax reforms commission or its workings, except for what is available publicly in newspapers.

Read also: State of tax exemptions

TNS: Tax exemptions are looked at as the other culprit. Can you elaborate on how bad are they for the system?

IN: Tax exemptions result in high loss of revenue due to preferential legal provisions (in the annual budget or through SROs) that provide certain types of businesses or individuals with special concessions -- zero or reduced rates and tariffs, or duty and tax exemptions. Research by the World Bank shows that the tax loss from these exemptions increased from 0.8 per cent of GDP in 2001 to 1.8 per cent in 2011, and that this estimate is a lower bound. (Source: World Bank 2013) This is a huge gap that can be plugged to substantially increase tax revenue.

There are also issues at the provincial level which are severely hampering the ability of provinces to provide essential services. In the context of devolution and the 18th Constitutional Amendment, when the provinces are responsible for more functions, this is critical.

One example is urban property tax, which is controlled by provincial governments in Pakistan. This tax is riddled with exemptions and other issues which keeps its collections extremely low. Research done by us in Punjab shows that as a proportion of total local government revenues and a share of GDP, the urban property tax is about one fifth of that collected by provinces in comparable countries, and that comprehensive reforms that remove exemptions, fix property valuations, increase the coverage net of properties and urban areas and rationalise tax rates, can radically increase Punjab’s property tax collection to many times more than current levels. The story of other provinces will be similar. (Source: Ijaz Nabi IGC and CDPR 2012)

Another example is agriculture income tax. Provinces have been extremely hesitant to fully levy this tax and implement it in earnest, resulting in horizontal inequity. Research by colleagues has shown that Punjab could have collected tax revenue of between Rs. 55 to 75 billion in 2010 if agricultural farm incomes had been taxed at the rates applicable to similar incomes in other sectors of the economy. Current collections are abysmally low. The story of Sindh is very similar. (Source: Anjum Nasim IDEAS and CDPR 2012)

TNS: What are the creative ways of improving the tax base. The government has devised some ways of drawing more people into the tax net. What else needs to be done? Can the tax filing system be improved in any manner?

IN: Minimise exemptions and special treatment of individuals/economic activity. Bring about horizontal equity among tax payers. Have credible audits. Put the full authority of the state behind FBR. Improve service delivery.

This article was published under the title “Reforms about tax administration are as important” in the September 6, 2015 issue of The News on Sunday.

Minimise exemptions and special treatment of individuals and economic activity