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The Future Path of Tax Reforms in Pakistan

Hafiz A. Pasha* and Aisha Ghaus-Pasha**

1.        Introduction

Pakistan’s taxation system has come under intense scrutiny in recent years. The country’s low and declining revenue yield has been attributed to wide-ranging concessions and exemptions, large-scale tax evasion, and a slack and corrupt tax administration. This has led to the perception of a virtual breakdown of tax compliance in the country.
Improving the tax effort has now become the lynchpin of any future economic reform process. Experience shows that this will require political determination in order to overcome the resistance from powerful vested interests. In addition, tax collecting agencies such as the Federal Board of Revenue (FBR), will need to undergo fundamental improvements to successfully implement the required changes in tax policy.
The objective of this chapter is to describe Pakistan’s taxation system both at the federal and provincial levels, followed by an in-depth diagnosis of the factors contributing to the exceptionally low tax-to-GDP ratio. We also assess the level of tax rates, the magnitude of tax expenditures (revenue losses due to concessions and exemptions in the tax code), and the extent of tax evasion.
Based on this diagnosis, we identify the key elements of a reform package in the areas of tax policy and administration. This set of reforms will promote transparency of the tax system, improve the progressivity of the tax burden, and remove distortions in the allocation of resources in the economy. Importantly, the various measures proposed will help in significantly raising the tax-to GDP ratio.

2.        The Taxation System

2.1.      Allocation of Fiscal Powers

The major taxes that can be levied at the federal level are given in Part I of the Federal Legislative List (FLL) in the Constitution of Pakistan. As shown in Table 7.1, this includes customs duties (including export duties), excise duties, taxes on income and corporations, sales tax, capital value tax, taxes on natural resources, capacity taxes, and terminal taxes on goods and passengers carried by different modes of transport. With the exception of capacity taxes, all these taxes are currently levied.
Table 7.1: Fiscal powers of the federal government as per the Constitution a
Item no. (FLL-1)
Included
Excluded b
43
Customs duties, including export duties
-
44 c
Excise duties, including duties on salt
Duties on alcoholic liquors, opium, and other narcotics
47
Taxes on income
Agricultural income
48
Taxes on corporations
-
49
Taxes on the sale and purchase of goods imported, exported, produced, manufactured, or consumed
Sales tax on services
50
Taxes on the capital value of assets
Taxes on property
51
Taxes on mineral oil, natural gas, and minerals used to generate nuclear energy
-
52
Taxes and duties on the production capacity of any plant, machinery, undertaking, establishment or installation
-
53
Terminal taxes on goods and passengers carried by rail, sea, or air; taxes on their fares and freights
-
Note: a = following the 18th Amendment, b = fall in the domain of fiscal powers of provincial governments, c = items no. 45 and 46 have been excluded (no. 45 included duties with respect to succession to property, no. 46 included estate duty with respect to property).
Source: Constitution of Pakistan (as updated up to the 20th Amendment).
The provincial governments have been given fiscal powers based on the exclusion of some parts of the federal tax bases. Agricultural income tax and property-related taxes have been declared provincial subjects. Following the 18th Amendment, the sales tax on services has been brought exclusively within the provincial domain. Further, all residual taxation powers are vested with subnational governments. This justifies the provincial governments’ imposition of taxes such as stamp duty, motor vehicle tax, and entertainment tax. Additionally, Article 163 of the Constitution enables these governments to levy a tax on persons engaged in professions, trades, and callings.

2.2.      Federal Taxes

The salient features of each federal tax are described below.
Income tax. This is levied under the provisions of the Income Tax Ordinance 2001. The legislation indicates the types of income liable to taxation, tax rates, types of tax exemptions, credits, deductions, and allowances.
Revenues from income tax accrue in the form of voluntary payments (along with the filing of returns), collection on demand (following assessment), and deductions at source (in the form of withholding and presumptive taxes). A universal self-assessment scheme is in operation with returns being subject to a stratified random audit. Currently, deductions at source are the major source of revenue with a share of 57 percent, followed by voluntary payments, which contribute 32 percent to revenues.
There are two types of withholding/presumptive taxes. The first includes taxes collected at the point of accrual of different types of income, such as salaries, export proceeds, dividends, and interest income. The second, presumptive taxes, are collected on income proxies such as electricity and telephone bills, the sale of automobiles, and air travel. The major deductions at source are on income from services and payments for contracts, imports, and salaries with shares of 25, 20, and 14 percent, respectively.
Sales tax. This is levied under the Sales Tax Act 1990 and covers only goods. It has the features of a value-added tax (VAT) with provisions for the tax invoicing of inputs and zero-rating of exports. The act describes the registration process, filing of returns, offences, and penalties. It contains seven schedules, of which the sixth schedule gives the list of exemptions.
Customs duties. The Customs Act 1969 enables the collection of customs duties. Duties on imports are specified in the First Schedule at the 8-digit level of the Harmonized System. Pakistan’s duty structure is cascaded by the level of value added, with the lowest tariffs on primary raw materials and the highest on finished goods. There are some tariff peaks on luxury items such as automobiles and there is a list of banned items such as liquor.
Exemptions and concessions are granted under different statutory rules and orders (SROs); some of the major SROs include the following:
No.
Description
565(I)/2006
Exemption from customs duty on the import of raw materials, subcomponents, components, subassembly, and assembly for the manufacture of specified goods (mostly automobiles)
575(1)2006
Exemption from customs duty on machinery and equipment
567(1)/2006
Exemption from customs duty on the import of specified goods (nonsurvey-based)
In addition, there are SROs covering free trade and regional trade agreements.
Excise duties. Federal excise duty is levied under the Federal Excise Act 2005. Some goods, such as cigarettes, are subject to supervised clearance under this act. The First Schedule lists excisable goods and the rates of duty, which are either specific or ad valorem. Following the broad-basing of the sales tax, the coverage of excise duties has been substantially curtailed.

2.3.      Provincial Taxes

The key features of the major provincial taxes are described below.
Sales tax on services. This was introduced simultaneously by the four provinces with the enactment of the Sales Tax Ordinance 2000. The tax has been integrated with the federal GST (VAT), as though it were leviable under Sections 3, 3A, or 3AA of the Federal Sales Tax Act 2000; all the provisions related to payment, registration, audit, enforcement, and penalties are the same. Initially, its coverage was extended at the standard rate of 16 percent to hotels, clubs, and caterers; advertisements on television and radio; courier services; telecommunication services; stockbrokers; and miscellaneous services provided at ports. The responsibility for collecting this tax was assigned to the FBR’s Inland Revenue Service, and revenues distributed among the provinces on the basis of population shares.
In 2011, the Sindh government introduced its own variant of the tax. It proposed creating its own capacity to collect the tax by establishing the Sindh Revenue Board. The tax no longer retains the features of a VAT and has effectively been transformed into a single-stage sales tax. Recently, the government of Punjab established the Punjab Revenue Authority.
Stamp duty. This was promulgated over a century ago, not as a fiscal statute but as a mechanism for authenticating a large number of instruments through the use of adhesive stamps. These stamps are classified as either judicial or nonjudicial. For example, the stamp duty on the value of a property sold is 2 percent.
Land revenue. This was originally promulgated under the Land Revenue Act 1887, and is essentially a land tax payable by owners of agricultural land. It is collected through the elaborate tax machinery of the provincial boards of revenue, which also maintain and update land records. Prior to 1947, land revenue was one of the main sources of revenue for the provincial governments.
Motor vehicles tax. This is levied under the Motor Vehicles Taxation Act 1958. Different lump-sum tax rates are specified for different types of vehicles, to be paid either once or annually. Persons with motor vehicles are obliged to make a declaration, pay the tax, and receive a license. The tax is collected by the provincial excise and taxation departments, and is intended to cover the costs of road operation and maintenance within the provinces. As such, the tax rises exponentially for larger vehicles. Motor vehicles tax rates vary among the provinces.
Urban immovable property tax. Introduced in 1958, the government levies this tax in urban areas that have been declared ”rating areas”. The tax is charged on the assessed rental value (ARV) of buildings and lands in a rating area at the rate of 20 percent. It is collected by the provincial excise and taxation departments on the basis of a formula for assessing the rental value contained in the valuation tables. Revenues from this tax are shared with local governments to the extent of 85 percent, after deducting 5 percent as the cost of collection. Properties that are owner-occupied and have an ARV of less than PRs 1,080 or are located on an area smaller than 5 marlas (125 square yards) are exempt.
The five taxes above account for more than 90 percent of the provincial governments’ tax revenues. The overall composition of tax revenues is given in Table 7.2. Federal taxes account for the bulk of revenues, with a share approaching 95 percent in 2011/12. The largest federal tax is the sales tax, which generates 39 percent of total tax revenues, followed by income tax at 35 percent. Customs duties and excise duties contribute 10 percent and 6 percent, respectively.
The share of provincial taxes is very small at only 5 percent, which is low in relation to countries like India where the share of state taxes is over 35 percent. The sales tax on services has emerged as the largest provincial tax, followed by stamp duties.
Table 7.2: Share of revenues from different taxes (PRs billion)
Tax
2007/08
Share (%)
2011/12
Share (%)
Federal
1,045.4
96.30
1,969.6
94.86
Direct taxes
387.9
35.72
731.9
35.26
Indirect taxes
622.5
57.33
1,153.7
55.58
Excise duty
86.5
7.97
126.2
6.08
Sales tax
385.5
35.50
809.3
38.98
Customs duty
150.5
13.86
218.2
10.52
Surcharge/levy
35.2
3.24
83.4
4.02
Petroleum levy
14.5
1.33
60.4
2.91
Gas development surcharge
20.7
1.91
23.0
1.11
Provincial
40.2
3.70
106.7
5.14
Stamp duty
11.3
1.04
16.5
0.79
Motor vehicle tax
7.8
0.72
11.1
0.53
Property tax
4.1
0.38
7.8
0.38
Others a
17.0
1.57
71.3
3.43
Total
1,085.8
100.0
2,075.7
100.0
Note: a = including land revenue, agricultural income tax, electricity duty, etc., and from 2011/12 onward, sales tax on services.
Source: Fiscal operation, Pakistan, Ministry of Finance.

3.        Tax Administration

The FBR is the federal government’s tax collecting agency. It comprises three types of members—line, functional, and support—under the chairperson. Line members are department heads who are directly responsible for tax collection, i.e., Customs, Inland Revenue (South), and Inland Revenue (North). The latter two departments are responsible for collecting income tax, sales tax, and federal excise duty.
Five functional members are responsible for inland revenue policy, taxpayer audits, legal issues, facilitation, and taxpayer education and enforcement, respectively. The support functions fall under members for administration, human resource management, strategic planning and statistics, and accounting and training. Withholding tax agents include employers, government departments/ministries, banks, telecommunication companies, electricity and gas distribution companies, airlines, and provincial taxation departments.
The provincial tax administrations comprise multiple agencies (Figure 7.1). The excise and taxation departments are responsible for collecting taxes from urban jurisdictions, such as property tax and motor vehicles tax. The provincial boards of revenue operate largely in rural areas and collect land revenue, agricultural income tax, and stamp duties. Following the 18th Amendment, the government of Sindh has established the Sindh Revenue Board primarily to levy and collect the sales tax on services. The government of Punjab has followed suit with the Punjab Revenue Authority.
At the federal level, the FBR’s costs of collection are estimated to be 0.6 percent of the revenues that accrue to it, with 0.5 percent in the case of the Inland Revenue Service and 2 percent for the Customs Department. The provincial costs of collection are equivalent to 3 percent of own-revenues, which is low by international standards.
Figure 7.1: Structure of tax administration in Pakistan
Note: SRB = Sindh Revenue Board, PRA = Punjab Revenue Authority.

4.        Tax-to-GDP Ratio

The overall tax-to-GDP ratio, inclusive of federal and provincial taxes, surcharges, and levies, was 10 percent in 2011/12 (Table 7.3). During the last decade, the tax-to-GDP ratio has shown a declining tendency, falling from a peak of 11.5 percent in 2002/03. During this period, FBR revenues declined by about 0.5 percent of GDP. The major part of the overall fall was due to surcharges/levy on gas and petroleum, oil, and lubricant (POL) products, respectively.
A positive development has been the rise in the direct taxes-to-GDP ratio from 3.0 to 3.6 percent, which has contributed to a more balanced and progressive tax system. Indirect taxes have fallen significantly from 6.9 to 6.1 percent of GDP, between 2000/01 and 2011/12.
Table 7.3: Tax-to-GDP ratio of Pakistan, 2000/01–2011/12
(percentage of GDP)
Year
Direct taxes
Indirect taxes
Surcharge/levy
Total taxes
FBR’s revenue
Share of direct taxes
2000/01
2.99
6.89
0.73
10.61
9.42
28.18
2001/02
3.20
6.41
1.23
10.83
9.11
29.54
2002/03
3.17
6.94
1.41
11.53
9.57
27.49
2003/04
2.92
6.84
1.09
10.84
9.25
26.94
2004/05
2.72
7.01
0.41
10.14
9.05
26.82
2005/06
2.82
7.06
0.67
10.54
9.36
26.75
2006/07
3.85
6.41
0.74
11.00
9.76
35.00
2007/08
3.79
6.47
0.34
10.60
9.83
35.75
2008/09
3.46
6.00
0.99
10.44
9.08
33.14
2009/10
3.66
5.83
0.90
10.39
9.05
35.23
2010/11
3.31
5.64
0.63
9.58
8.60
34.55
2011/12
3.58
6.06
0.40
10.04
9.12
35.65
Source: Pakistan, Ministry of Finance.
Table 7.3 also shows the structure of tax revenues. Pakistan appears to rely heavily on indirect taxes, especially on taxes on goods and services. This also suggests that the major focus of tax reforms in the country will have to be on further enhancing the share of direct taxes.
Table 7.4 shows that Pakistan has the lowest tax-to-GDP ratio among 13 selected developing countries. The centrally collected tax-to-GDP ratio of India and Pakistan is more or less, the same, but the contribution of subnational taxes is substantially larger in India. The average tax-to-GDP ratio of the 13 countries is 14 percent compared to less than 10 percent for Pakistan. This is the first (crude) estimate of the “tax gap” in Pakistan.
Table 7.4: Comparison of tax-to-GDP ratio and taxation structure in selected countries



Percentage share of taxes on
Country
Year
Tax-to-GDP ratio (%) a
Profits, income
Goods and services
International trade
Bangladesh
2011
10.0
26.7
36.9
36.6
Brazil
2010
15.3
43.4
52.9
3.7
China
2009
10.5
28.2
67.5
4.2
India
2010
9.7
56.5
28.1
15.4
Indonesia
2010
10.9
53.7
43.4
2.9
Malaysia
2010
13.8
77.7
19.5
2.8
Pakistan
2011
9.3
34.6
52.7
12.7
Philippines
2011
12.3
47.6
30.3
22.1
South Africa
2010
26.0
56.5
39.5
4.0
Sri Lanka
2011
12.4
21.8
56.4
21.8
Thailand
2011
17.6
46.4
48.2
5.4
Turkey
2010
20.6
31.4
67.0
1.6
Egypt
2010
14.1
48.5
42.3
9.2
Average
(13 countries)
2009–11
14.0
43.6
45.0
11.4
Note: a = federal/central taxes only.
Source: World development indicators, World Bank.
Next, we examine the factors that have contributed to Pakistan’s low tax-to-GDP ratio by isolating the “base” and ”rate” effects on the change in the tax-to-GDP ratio. The “base” effect arises when the relevant tax base rises faster/slower than GDP, while the “rate effect” comes into play when the effective tax rate on the tax base rises/falls. The methodology used to identify the two effects is given in the Appendix.
The analysis spans the period 2007/08 to 2010/11 (see Table 7.5). The main reason for the significant fall in the FBR’s tax-to-GDP ratio (by over 1.2 percent of GDP) is the large negative base effect. The two primary tax bases in the economy, large-scale manufacturing and imports, grew little during these years. The former has largely remained static while imports showed a growth rate of only 1 percent in dollar terms.
Table 7.5: Base and rate effects on the change in taxa-to-GDP ratio, 2007/08 to 2010/11 (%)
Tax
Base effect
Rate effect
Change in tax-to-GDP ratio
Direct taxes
-0.03
-0.50
-0.48
General sales tax
-0.56
0.30
-0.26
Customs duties
-0.28
-0.15
-0.43
Excise duties
-0.12
0.06
-0.06
Total
-0.99
-0.24
-1.23
Note: a = only federal taxes.
Source: Authors’ calculations.
The Social Policy and Development Centre (2008), however, concludes the opposite where the base and rate effects are concerned. Between 1999/2000 and 2006/07, the tax-to-GDP ratio rose by 0.7 percent with a large positive base effect of 3.0 percent of GDP; this was largely neutralized by a sizeable negative rate effect of 2.3 percent of GDP. The large-scale manufacturing sector grew by over 11 percent and imports expanded rapidly at the rate of 15.7 percent per annum. In fact, the economy should have witnessed major ”fiscal drag”[1] during this period of fast growth, but the revenue gains were largely frittered away by the policy to reduce tax rates.

5.        Tax Rates

Tax rates were brought down sharply by the military government. The maximum income tax rate on individuals and associations of persons (AOPs) was scaled down from 35 to 25 percent in the Finance Bill of 2006/07. Tax rates were reduced substantially for small companies (from 45 to 25 percent) and for banking companies (from 50 to 35 percent), in a staggered manner.
The maximum import tariff was brought down from 45 to 25 percent by 2002/03, along with a cascading down of the overall tariff structure as part of the process of trade liberalization. This simultaneously affected revenues from sales tax at the import stage and from the presumptive income tax on imports. The rate of excise duty on cigarettes was also reduced. Overall, it appears that the Musharraf government essentially followed a supply-side strategy of bringing down tax rates in order to boost the economy. The tax bases did expand but not enough to enable a major jump in revenues.
The subsequent democratically elected government had to reverse this policy somewhat in the face of a declining tax-to-GDP ratio. A minimum income tax was introduced, while the maximum tariff on imports was raised once again to 35 percent and brought down to 30 percent in the Finance Bill of 2012/13. The standard sales tax rate was raised from 15 to 17 percent, and only recently reduced to 16 percent. An across-the-board special excise duty of 2 percent was introduced on imports and domestic manufacturing, but withdrawn in 2012/13 in the lead-up to the elections.
Following these changes in the tax policy, how do Pakistan’s tax rates now fare in international comparisons? Table 7.6 shows that the corporate tax rate on large companies is relatively high at 35 percent as opposed to the average of 27 percent in the 13 selected countries. However, the maximum individual income tax rate appears to be relatively low at 25 percent, while the standard sales tax rate is on the higher side. These conclusions suggest the future direction of changes in tax rates.
Table 7.6: Comparison of tax ratesa in selected countries (%)
Country
Corporate tax rate (large companies)
Individual income tax
(maximum rate)
VAT/GST rate
Bangladesh
45
25
15
Brazil
34
27.5
17–25
China
25
45
17
India
13
33
5.5–14.5
Indonesia
25
30
10
Malaysia
25
26
-
Pakistan
35
25
16
Philippines
30
32
7–12
South Africa
28
40
14
Sri Lanka
35
35
12
Thailand
20
37
7
Turkey
20
35
18
Egypt
20
20
10–25
Average
27
32
12–16
Note: a = federal/central taxes only.
Source: http://en.wikipedia.org/wiki/List_of_countries_by_tax_rates

6.        Tax Exemptions and Concessions

Along with the reduction in statutory tax rates, the Musharraf government granted wide-ranging exemptions and concessions that contributed further to the reduction in the “effective” tax rates. These included the following measures:
-       Abolition of the wealth tax
-       Exemption granted on capital gains from shares
-       Zero-rating of the domestic sales of major export sectors, such as textiles
-       Exemption from sales tax granted to agricultural inputs, such as fertilizer and pesticides
-       Exemption from sales tax granted to plant and machinery
-       Promulgation of a large number of SROs for exemption from or concession in import duties.
Presumably, these measures were taken to gain the support of powerful interest groups.
According to Bari (2012), the one exemption that was granted to capital gains from shares led to a huge cumulative revenue loss of over PRs 1,000 billion between 2003/04 and 2006/07, at a time when the stock market was booming and the share price index had jumped up by 280 percent. This massive tax break led to the emergence of a new class of big capitalists in the country, who had invested heavily in the stock exchange.
This brings us to a very basic question: How far has Pakistan’s tax-to-GDP ratio been eroded by exemptions and concessions? This requires estimating tax expenditures, defined by Atshuler and Dietz (2008) as “revenue losses attributed to tax laws which provide for a special exclusion, exemption, deduction, tax credit, preferential rate of tax or a deferral of tax liability.” The word “special” refers to tax breaks that are not commonly observed in tax systems internationally.
The Pakistan economic survey for 2011/12 gives an official estimate of PRs 186 billion as the value of tax expenditures incurred under federal taxes, which is equivalent to 0.9 percent of GDP (Pakistan, Ministry of Finance, 2012). The largest share is that of customs duties (49 percent) followed by income tax (38 percent). This compares with an estimate of 5.1 percent of GDP as India’s total tax expenditure, with the largest share (54 percent) accounted for by customs duties. The corresponding estimates by Mortaza and Begum (2006) for Bangladesh are 2.5 percent of GDP, with 90 percent accounted for by indirect taxes. As such, tax expenditures appear to be lower in Pakistan.
In the following subsections, we provide, for the first time, a comprehensive estimation of tax expenditures in Pakistan, inclusive of both federal and provincial taxes. Presented in Table 7.7, these estimates are almost three times the official estimates, at PRs 550 billion in 2010/11, which is equivalent to 3 percent of GDP. A detailed description of the tax expenditures is given below.
Table 7.7: Major tax expenditures in Pakistan
Tax/head
Tax expenditure
(PRs billion)
Percentage share
Federal
466
83
Direct taxes
164
30
Exemptions
46

Deductions/allowances
88

Concessionary tax rates
30

General sales tax on goods
91
16
Exemptions
70

Zero rating
21

General sales tax on services
64
12
Exemptions
64

Custom duties
136
25
Exemptions
44

SROs
80

FTAs
12

Excise duty
11
-
Exemption of luxury goods
11

Provincial
95
17
Agricultural income tax
50

Urban immoveable property tax
30

Capital gains tax
15

Total
561
100
As percentage of revenues
34

As percentage of GDP
3

Source: Authors’ calculations.

6.1.      Federal Taxes

The main federal taxes levied are described below.
-       Income tax. The major tax expenditures in 2010/11 included an accelerated depreciation allowance at 50 percent[2] in the first year (PRs 55 billion),[3] a capital gains exemption on shares (PRs 22 billion), a 30-year tax holiday[4] for independent power producers (PRs 12 billion), tax deductions on loan provisioning by commercial banks (PRs 9 billion), an exemption on profit from Behbood savings certificates (PRs 9 billion), tax deductions on charitable contributions (PRs 2 billion), a concessionary presumptive income tax on the export of goods (PRs 16 billion), the exemption of export income from services (PRs 1 billion), and others[5] (PRs 28 billion).
-       Sales tax on goods. This includes exemptions on goods (PRs 64 billion) including agricultural inputs, machinery, processed foods, pharmaceuticals, etc.; and the zero-rating of domestic sales of export-oriented sectors such as textiles and leather (PRs 21 billion) (Social Policy and Development Centre, 2010).
-       Sales tax on services. This includes exemptions on services (PRs 70 billion) (Ghaus-Pasha, 2011), including those listed in the First Schedule but not in the Second Schedule of the Sales Tax on Services Act.
-       Customs duty. This includes zero duties on POL products, fertilizer, and cotton (PRs 44 billion); exemptions in SROs, especially SRO 567(I)/2006, 565(1)/2006, and 575(1)/2006 (PRs 80 billion); and preferential rates of duty in trade agreements, especially with China (PRs 12 billion).
-       Excise duty. This refers to exemptions on luxury goods such as air-conditioners, freezers, large automobiles, televisions, perfumes, and cosmetics (PRs 11 billion).

6.2.      Provincial Taxes

The main provincial taxes levied include:
-       Agricultural income tax. Low presumptive rates of taxation (Institute of Public Policy [IPP], 2010) (PRs 50 billion).
-       Urban immoveable property tax. Low presumptive rates of gross annual rental values, preferential treatment of owner-occupied properties, and lack of extension of rating areas (PRs 30 billion).
-       Capital gains tax. Exemption on properties (PRs 15 billion).

6.3.      Analysis of Tax Expenditures

Some important conclusions emerge from this analysis of tax expenditures:
1.        Tax exemptions and concessions in direct taxes (income, capital gains, and property taxes) account for a tax expenditure of almost PRs 260 billion, equivalent to 46 percent of the total. There is, therefore, empirical evidence to support the perception that tax breaks in Pakistan disproportionately benefit the rich and powerful, including the feudal class, the textile lobby, trading community, property owners, and investors in shares.
2.        The structure of customs duties has been perverted by the large number of SROs and exemptions granted to industries such as automobiles, fertilizers, and textiles. The duty structure needs to be rationalized by adhering to the principle of standard statutory rates to enable proper cascading by the level of value added.
3.        In the case of the sales tax, the strategy must consist primarily of broadening the tax base, especially by bringing those services into the tax net that have grown rapidly and are consumed chiefly by the upper-income groups.

7.        Incidence of Taxes

It is useful to derive explicitly the implications of features of the tax system in terms of who bears the burden of taxes in Pakistan. Wahid and Wallace (2010) have derived these for the year 2007/08 as part of a study commissioned by the FBR. The pattern of incidence is given in Table 7.8, according to which the burden appears to be mildly progressive, despite the numerous tax expenditures on the richer segments of society.
Table 7.8: Incidence of taxes in Pakistan, 2007/08

Taxes paid as percentage of income
Decile
Direct taxes
Indirect taxes
Total taxes
1
2.01
6.42
8.43
2
2.20
6.17
8.37
3
2.18
6.08
8.26
4
2.30
6.20
8.50
5
2.35
6.59
8.94
6
2.38
6.73
9.11
7
2.50
6.26
8.76
8
2.91
6.82
9.73
9
3.35
6.28
9.63
10
6.38
6.74
13.12
Source: Wahid and Wallace (2010).
However, there is reason to believe that the tax burden has become less progressive since 2007/08. First, the incidence of indirect taxes on the lower income deciles has increased because of the change in the contribution of different commodities to revenues. In particular, the share of revenues collected from POL products has risen from 19 percent in 2007/08 to over 32 percent by 2011/12. The bulk of revenues accrue from HSD oil, which is used primarily for public transportation.
Second, the incidence of withholding taxes, especially on imports, contracts, electricity, and telephones, is likely to be more regressive than allowed for in the methodology used by Wahid and Wallace (2010). In fact, Kemal (2008) demonstrates that the overall incidence of taxes was regressive in 1999/2000. More recently, Qadir (2011) has calculated the burden of indirect taxes by quintile in 2008/09. The results indicate that the incidence is substantially more regressive than indicated by the FBR study.

8.        Tax Evasion

Tax evasion is commonly perceived as being rampant in Pakistan. The two statistics frequently cited to highlight this are, first, that only one in 100 persons in the country pays income tax, and second, that more than 60 percent of parliamentarians do not file their tax returns. However, it needs to be recognized that Pakistan has an elaborate withholding tax regime that has played a major role in curbing evasion. It is estimated that, as a result of these deductions, the actual number of taxpayers is substantially larger than perceived. This is because:
-       payments are made on over 100 million mobile/line phones on bills/prepaid cards,
-       almost 17.7 million bank accounts contribute to income tax via the fixed tax (at 10 percent) on interest income, and
-       over 306,800 industrial units and over 2.9 million commercial enterprises pay income tax in the form of withholding tax on electricity bills.
The income tax net is thus wider than perceived due to the presence of a large number of deductions at source. The problem is that the payments are usually small and the element of progressivity has not been built into the withholding/presumptive tax regime.
Additionally, there is too much emphasis on personal income tax evasion. It is likely that more revenues could be generated by focusing on corporate tax evasion. The numbers are striking: out of the 52,800 or so companies registered with the Securities Exchange Commission of Pakistan, less than a third file returns, and out of those who do, only a fifth actually declare taxable profits. The State Bank of Pakistan (2008) estimates the additional revenues that could be generated if tax evasion was curbed to be 2.5 percent of GDP while Junaid (2011) calculates the share to be 3 percent of GDP.

9.        Tax Reforms

Based on the above analysis, we now identify the package of reforms required in tax policy and administration to achieve a major jump in the tax-to-GDP ratio. The primary focus is on direct taxes, not only in order to increase the yield but also to make the tax system more progressive.

9.1.      Tax Policy

The major steps required are explained below.

9.1.1.        Direct Taxes

Effective agricultural income taxation. As per the Agricultural Income Tax Act enacted by the provincial governments in 1947, the present structure comprises either a fixed presumptive tax (with an exemption limit) per acre or a progressive rate structure on actual agricultural income (with scope for substantial deductions). The presumptive tax rates vary from only PRs 150 to PRs 250 per acre, which is less than 1 percent of the net income per acre. These rates need to be raised substantially. Simultaneously, the penalty for failing to file a return should be raised from the present maximum amount of PRs 1,000 to 100 percent of the assessed tax, following the detection of nonfiling.
Development of personal income tax. This is considered a prerequisite for signaling greater equity in the tax system, and could help raise taxpayer compliance generally.
Taxation of assets. As indicated earlier, a wealth tax was levied on individuals up to 2000. It was an indicator of equity in the tax system and wealth returns also provided collateral evidence of income. This tax should be reintroduced; alternatively, a minimum assets tax could be levied at 1 percent of global net assets, as the minimum income tax payable.
Minimum tax on turnover. As mentioned above, a very small percentage of companies actually pay corporate income tax. Although a minimum tax on turnover was introduced in the Finance Bill of 2009/10, it was withdrawn in the Finance Bill of 2012/13. There is a strong case for reintroducing this tax with the usual carry-forward provisions in order to curb corporate tax evasion.
Withdrawal of tax expenditures. As is the case in India, transparency and the proper accounting of tax expenditures should be introduced as part of the information provided when the budget is presented to Parliament. This will enable public debate on which exemptions and concessions are justified.
Direct taxes. Initially, the following tax expenditures need to be effectively targeted:
-       capital gains (short- and long-term) on shares and property
-       tax holidays beyond five years
-       reduction in the first-year depreciation allowance
-       tax deduction on loan provisioning by banks (to be allowed only for priority sectors such as small and medium enterprises, agriculture, and exports).
Rationalization of tax rates. The divergence in tax rates between individuals, and small and large companies needs to be eliminated. The corporate tax rate on large companies (especially those that are publicly quoted) could be brought down gradually to 30 percent. Simultaneously, the maximum tax rate on individuals and AOPs/small companies could be raised to 30 percent. This would encourage the process of corporatization in the economy and imply a more progressive personal income tax structure.
Moving from schedular to comprehensive income taxation. Currently, most forms of unearned income are taxed at source as separate blocks of income at a fixed and final rate of 10 percent. As highlighted earlier, this has reduced progressivity. These fixed taxes should be converted into withholding taxes in the case of income from bank deposits, savings schemes, dividends, and interest on securities and prize bonds, etc. This will also enable persons whose total income is below the exemption limit to claim refunds.
Fixed taxes are also levied on income proxies. In the case of contractors, suppliers, service providers, and importers, we propose a scheme whereby the current fixed rate is raised for taxpayers who want to make this their final payment, and a lower rate for those who prefer to make a withholding tax payment and include the income derived in their returns. This could promote the process of documentation in the economy.
Development of property tax. This will involve extending rating areas, levying a higher tax on commercial properties, and reassessing gross annual rental values.
Incentives for filing returns. Numerous incentives could be offered to taxpayers (AOPs and small companies) who have regularly filed their returns over a period of two years with no under-declaration or short payment. These incentives could include the following:
-       some preference in contracts for suppliers to government departments;
-       a guaranteed refund within the stipulated time;
-       access to a bank loan up to a certain limit;
-       provision for the carry-forward of losses;
-       partial or full exemption from withholding taxes, contributing thereby to an improved cash flow position;
-       preferential treatment in obtaining access to public services such as passport issuance and electricity or gas supply; and
-       tax credit.
These incentives could induce a significantly higher number of tax returns.

9.1.2.        Indirect Taxes

Proposals to reform indirect taxes include the following:
Introduction of a broad-based integrated VAT. The passage of the VAT bill of 2010 should be reconsidered. Recent developments such as the establishment of separate tax machinery to collect the sales tax on services by the provincial governments of Sindh and Punjab have made the task of integration more difficult, and have complicated the process of input-tax invoicing services in manufacturing and manufactured goods in services. A system for recording tax invoices issued across provincial boundaries and of credits/refunds between governments needs to be introduced.
Broad basing has considerable scope, especially in the area of services. For example, the services tax in India is levied on 125 services and generates 1 percent of the country’s GDP. In Pakistan, major services that are not covered by the sales tax on services include credit cards, security, consultancy, accountancy, legal, airport, and air travel agent services. Such services are consumed mostly by corporate entities or upper-income groups. The standard rate could be brought down to 12.5 percent once again, following the broad basing.
Rationalization of customs duties. The statutory tariff rates (by nature of the good in terms of value added) must be adhered to with essentially three slabs of 5 percent, 15 percent, and 25 percent, respectively. Simultaneously, most SROs, except those pertaining to trade agreements, should be withdrawn.
Additionally, in order to eliminate the problem of under-invoicing, a system of minimum import prices could be introduced for some commodities, with the provision that these prices be periodically revised. This system was in operation in Pakistan in the 1990s and does not violate World Trade Organization rules, if used selectively.

9.2.      Tax Administration

FBR. Radical changes are required to make the FBR more effective in implementing reforms in tax policy and collecting more revenues. The following measures need to be undertaken on a priority basis:
-       Converting the FBR into an autonomous revenue authority
-       Strengthening the Revenue Division of the federal Ministry of Finance to formulate tax policy
-       Requiring tax officials to file asset declarations periodically
-       Strengthening the tax ombudsman and vesting him/her with judicial powers
-       Strengthening the FBR internally in the areas of audit and intelligence
-       Developing a data warehouse linked particularly to withholding tax payments
-       Streamlining the process of payment of refunds
-       Augmenting the quality of human resources
-       Publishing an annual tax directory of payments by taxpayers.
Provincial tax administration. The following proposals need to be considered:
-       Reducing the multiplicity of taxes by abolishing taxes such as the cotton fee, entertainment tax, and tax on property transfers that generate low yields
-       Avoiding overlapping taxes, for example, on property by “piggy-backing” on federal taxes
-       Merging the Excise and Taxation Department with the Revenue Board/Authority, following the process of screening officials
-       Making intensive efforts to streamline business processes and to introduce information and communications technology, especially to enable taxpayers to e-file their returns or make payments
-       Appointing a provincial tax ombudsman, also vested with judicial powers
-       Augmenting the quality of human resources
-       Publishing a tax directory of payments of agricultural income tax and urban immoveable property tax.
Clearly, this agenda of reforms is an ambitious one, but it has become necessary in the presence of a low and falling tax-to-GDP ratio and the incipient breakdown of Pakistan’s tax culture. However, it will require strong political will and the capacity building of the implementing institutions. If the proposed reforms are put in place within the next two years, they could yield a conservative estimate of almost PRs 500 billion—equivalent to an additional amount over 2 percent of GDP (see Table 7.9).
Table 7.9: Revenue yield from tax reforms (with a tax base of 2012/13*)
Direct taxes
Revenue yield*
(PRs billion)
Effective agricultural income taxation
60
Taxation of assets
50
Minimum tax on turnover of companies
22
Withdrawal of tax expenditures
130
Total
262
Indirect taxes

Introduction of a broad-based integrated VAT
140
Withdrawal of SROs in customs duties
96
Total
236
Overall total
498
Percentage of GDP
500
Note: * = 20 percent above the estimates given in Table 7.7.
Source: Authors’ estimates.

10.     Conclusion

Pakistan’s low and declining tax-to-GDP ratio has been attributed to the major tax bases’ lack of buoyancy, low personal income tax rates, wide-ranging exemptions/concessions, and widespread tax evasion, leading to large revenue losses. There are also serious perceptions of inequity and corruption in the tax system, which have gravely affected tax compliance such that the tax culture in the country stands in danger of breaking down.
This chapter has, accordingly, proposed a structural and radical reforms agenda both in the areas of tax policy and administration. These reforms will go a long way in making the tax structure more progressive, reducing tax evasion, and raising the revenue yield in the next two years by over 2 percent of GDP.


References
Atshuler, R., & Dietz, R. D. (2008). Tax expenditure estimation and reporting: A critical review (Working Paper No. 14263). Cambridge, MA: National Bureau of Economic Research.
Bari, S. (2012). Tax expenditures in Pakistan. Unpublished master’s thesis, Beaconhouse National University, Lahore, Pakistan.
Ghaus-Pasha, A. (2011). Net VAT revenue from services (Report prepared for Federal Bureau of Revenue). Islamabad, Pakistan: Federal Bureau of Revenue.
India, Ministry of Finance. (2012–13). Estimates of revenue foregone. New Delhi, India: Author.
Institute of Public Policy. (2010). State of the economy: Pulling back from the abyss. Lahore, Pakistan: Author.
Institute of Public Policy. (2012a). Taxpayer perceptions in Pakistan (Report prepared for Federal Bureau of Revenue). Lahore, Pakistan: Author.
Institute of Public Policy. (2012b). Tax policy and enterprise development (Report prepared for Governance Institutes Network International. Lahore, Pakistan: Author.
Junaid, N. (2011). The size of the informal economy. Unpublished master’s thesis, Beaconhouse National University, Lahore, Pakistan.
Kemal A. R. (2008). Income inequalities in Pakistan: A strategy to reduce income inequalities. Islamabad, Pakistan: Ministry of Finance, Poverty Reduction Strategy Paper Secretariat.
Mortaza, H. G., & Begum, L. (2006). Tax expenditures in Bangladesh: An introductory analysis (Policy Note No. 0706). Dhaka: Bangladesh Bank.
Pakistan, Ministry of Finance. (2012–13). Pakistan economic survey. Islamabad, Pakistan: Author.
Pasha, H. A. (2010, August). Fiscal reforms in Pakistan. Paper presented at the Workshop on Collaborative Research on South Asian Tax Systems, Governance Institutes Network International, Singapore.
Pasha, H. A. (2012). Sub-national tax powers in Pakistan. Ottawa, Canada: Forum of Federations.
Pasha, H. A., & Ghaus-Pasha, A. (2003). Why has the tax-to-GDP ratio fallen? (Policy Paper No. 21). Karachi, Pakistan: Social Policy and Development Centre.
Qadir, A. (2011). Who bears the burden of indirect taxes in Pakistan? Unpublished master’s thesis, Beaconhouse National University, Lahore, Pakistan.
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Social Policy and Development Centre. (2010). Revenue potential of VAT on goods (Working Paper No. 6). Karachi, Pakistan: Author.
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Appendix
The methodology for decomposing the change in the FBR’s tax-to-GDP ratio into “base” and “rate” effects respectively is described below.
We designate the following:
T = actual tax revenue
t = effective tax rate
b = tax base
Y = GDP
That is, T = tB
The tax bases for different taxes are as follows:
Tax
Tax base
Direct taxes
Nonagricultural GDP
Sales tax
Imports + large-scale manufacturing + banking and insurance + telecommunications
Customs duties
Imports
Excise duties
Large-scale manufacturing
Subscripts 0 and 1 designate the base and terminal years, respectively.
The change in the tax-to-GDP ratio is given by
That is,
                                                (1)
Equation (1) gives the expressions for the base and rate effects, respectively.








* The author is dean of social sciences at Beaconhouse National University, Lahore.
** The author is director of the Institute of Public Policy at Beaconhouse National University.
[1] ”Fiscal drag” occurs when fast economic growth leads to an increase in the tax-to-GDP ratio.
[2] The normal depreciation rate is 8–10 percent.
[3] The magnitude of tax expenditures is given in parentheses.
[4] The normal tax holiday period is five years.
[5] Including tax deductibility of payments to Workers’ Welfare Fund and Workers’ Participation Fund, tax credit for provident funds, exemption on income from trusts, concessionary rates of sales tax, and lower income tax rates for suppliers and teachers. 

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posted by S A J Shirazi @ 12/27/2013 11:29:00 AM,

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