Since the last two decades, Pakistan has undergone various economics difficulties. Recurrent political adjustments caused by lack of consistent policies and their implementation, poor governance, externally caused disasters like floods, terrorism activities etc has struck the country's economy adversely. In order to finance and construct such policies, foreign financial assistance has always been in need. This is because the amount of tax revenue collected annually has never been adequate for such development as well as recurrent expenditures.
A Historical overview of the Taxation Structure, the tax network and tax compliance in Pakistan
The taxation structure and its compliance by the people vary from country to country. It is the responsibility of the Government to tax the public in the manner they see fit, in order to run the country.
For Pakistan, the 1973 Constitution lays down all the rules and regulations needed for all the tiers of the Government to function systematically. Therefore, the reviewing constitution is the first step to take in order to explain the functioning of the country, whether from a social aspect or from a financial one.
Under the finance chapter, Article 160 of National Finance Commission, the Constitution of Pakistan clearly defines the rules required for the distribution of the revenues between the federal Government and the Provincial Government. It defines the taxation system and structure that should be implemented in the country. According to the 1973 Constitution, taxes are imposed by the authority of the Parliament of Pakistan and it is the responsibility of the Federal Board of Revenue to enforce and collect these taxes. This tax is defined there as:
"taxes on income, including corporation tax but not including taxes on income consisting of remuneration paid out of the federal Consolidated Fund." (Constitution of Pakistan, 1973)
These taxes also include taxes on sales and purchases of goods which are domestically produced and consumed, export duties on raw materials, excise duties on imports and other taxes specified by the President.
Structure of Taxation through the Ages
The taxation structure of Pakistan has undergone changes throughout the years but to no avail. There has been slight improvement in the collection of tax revenue through the years but the ratio of tax to GDP has been not been improving as much. In order to better understand the mechanism and the structure of Pakistan's taxation system it is important to review the responsibilities which comes under the different tiers of the Government.
Review of Federal and Provincial Taxation Structure
The structure of the Government of Pakistan is important to consider in explaining the structure of the taxation department. The government is divided into three tiers and its responsibilities and functions are outlined clearly in the 1973 constitution. These are the Executive, the Legislative and the Judiciary. Under the Legislative powers, the federal government carries its functions under the federal legislative list. According to Akbar Zaidi (2005):
The federal legislative list includes functions of a regulatory and service nature. Service functions include defence, external affairs, currency, stock exchanges, national highways and strategic roads, railways, etc.(Zaidi, 2005)
After this there is a Concurrent Legislative List. This list of functions are performed by either federal or/and provincial governments. These functions include population planning, electricity (except KESC), tourism, vocational/technical training etc. Lastly, the residual functions are the responsibility of the provincial government including law and order, justice, public transport etc. Despite its acknowledgment in the Legal Framework Ordinance 2002, the existence of the local government as well as the District Government is not officially recognized in the 1973 Constitution. Due to this non recognition of the local government, many of the functions which should be performed by, or not are the responsibilities of the provincial government, are delegated to the local government most of the time. However, the role of the local government was recognized in the 1979 when the Local Government Ordinance was passed. Unfortunately it was implemented only in Punjab, Sindh and the then NWFP. In 1980, the same ordinance was extended to Balochistan till 2001 ordinance, which replaced them all.
After reviewing the structure of the Governmental hierarchy of Pakistan, it will help to systematically define the structure of the taxation system of the country itself.
Tax structure is the most integral part of the whole taxation system of the country. The Federal Tax Structure is made up of a large share of Income tax, General Sales tax, which was introduced in 1996 in Pakistan taxation structure, and the Custom duties. All these three taxes are collected by the Central or now the Federal Board of Revenue. The provincial tax structure is divided into three major categories; the Excise and taxation, land revenue and the funds provided to and collected by the local government. The Excise and taxation department is responsible for collecting the property tax, motor vehicle, the professional tax as well as the provincial excise. The land revenue includes the land related levies other than property.
Theoretically the sales tax on services should be a part of the Excise and Taxation, but unfortunately in Pakistan, the imposition and the calculation of such a tax has not been deciphered yet.
Elasticity of Indirect and Direct Taxation System
It is not as much as the tax rates itself which impacts the economy, but the elasticity and buoyancy of these taxes which helps determine the impact on the revenue. The elasticity of tax determines the responsiveness in tax revenue which is caused by a percentage change income or GDP. On the other hand, buoyancy measures the total response of revenue from changes in income or GDP. As tax rates increase over time therefore the buoyancy of tax rates, whether as a whole or individual tax, is greater than elasticity.
The extend of elasticity depends on the nature of the tax; whether it is a direct tax or an indirect tax, whether it is specific or ad valorem in character, its tax to base ratio etc. In the case of federally administered taxes, the direct taxes include income tax, corporation tax, wealth tax and property tax where as the indirect taxes include the sales tax, excise duty, exports duty, foreign travel tax etc.
Pakistan has never been able to raise its ratio of tax revenue to GDP more than 13 percent. According to Faiz Bilquees (2004), there are three major weaknesses in the tax system of the country which has caused such a failure, "narrow and distorted tax base, over-reliance on indirect taxes, and weak tax administration."
By observing the figures of direct and indirect taxes over the FY of 1974 to 2003 in the table below, it depicts the inadequacy of generating revenue and that ratio of tax to GDP has been not more than 13%. While Faiz Bilquees (2004) described the data below he said:
"The share of direct taxes remained very low until late 1980s, averaging 2 percent of the GDP, largely due to the extended tax holidays and exemptions in the 1960s and early 1970s, but picked up in the early 1990s. These increased by more than 3 percent of the GDP in the early 1990s and averaged 3.5 percent of GDP between 1995 and 2003. The share of indirect taxes averaged between 11-12 percent from late 1970s to mid-1990s, and registered a decline thereafter to around 9 percent of GDP. However, over time, the shift in the shares of direct and indirect taxes as a percent of total taxes has been quite significant. The share of direct taxes increased from 13 percent in 1974-75 to 35 percent in 2001-02, but declined to 32.3 percent in 2002-03, while that of the indirect taxes declined from 86.8 percent to 68 percent over the same period." (Bilquees, 2004)
Source: Pakistan Economic Survey (various issues)
According to the recent data of 2010 to 2011 from the Economic Survey of Pakistan, the federal indirect tax to GDP was around 5.3 percent while indirect tax to GDP was around 3.3 percent.
All income tax in Pakistan is not hundred percent direct taxes. The reason behind this is the withholding tax. Withholding tax is technically taxation at source. This means that when a tax payer's salary is paid, his withholding tax is cut when the tax payer is paid his salary. On the other hand, withholding tax is cut on wholesale or bulk supply by the purchaser before paying the due amount and this withholding tax should be filed to the income tax department by him. Same is the case of tax on services, custom duties etc.
Effectiveness of the Taxation Structure on Tax Compliance in Pakistan
The success of a taxation system of a country depends on the extent of compliance to the tax rates by the tax payers of Pakistan. It was recorded that in 2011-12 about 1.4 million filed their income tax returns, out of the 17 million people in the country. In addition to this, about 40,000 business units filed sales tax returns. Even these figures are a popular misconception among the country especially the statement that one percent Pakistanis pay taxes. The reason behind this is that millions of consumers pay indirect taxes in the form of sales tax, federal excise duties etc. These are counted as the income tax paid by the taxpayers.
There are few ways in collecting income tax in advance. Before the 30th June of every year, the tax payer has to show evidence to the income tax department that he has settled his taxes for the respective year; this is called filing a return of that fiscal year. For other cases, income taxes are cut in advance in the form of withholding tax. This causes income tax to be regressive because withholding tax has to be paid by everyone regardless their income. But for the taxpayers who earn salaries, it is not regressive because they pay according to the normal tax rate. For the salaries, this tax is considered as the final tax liability. This is proved to be injurious to the tax payers because the tax is cut on the principle payment and not on the profit after deducting the expenses. This shows that those who earn more, pays more tax but it is on the contrary. A lot of taxes go in the collection of withholding tax. Thus a large amount of income tax is collected under the withholding tax. Thus the income tax structure is not entirely progressive. Furthermore, a subset of withholding tax is the presumptive tax which assumes that the tax deducted is considered to be the final tax liability and it is applicable on salaries, payments, supplies and imports. Following is the table showing the collection of withholding taxes and its growth in fiscal year 2004-05.
Source: CBR Yearbook, 2005-06
The increasing reliance on withholding tax in clearly shown in the table as it has contributed about 57.5% in FY 2005-06. The gross collection was increases to 76.9% and there was a major growth of 25.2% in the tax revenue.
Inefficiency/Efficiency of Tax Network and the Macro economy
The tax network of Pakistan is different for every federal tax. For the income tax, the tax payers are required to file their tax return at the end of every fiscal year which is June 30th (trend over years). Furthermore, those who file their tax returns to the income tax department, FBR give a number to the filer called the NTN. This stands for the National Tax Number. In recent years there is a decreasing trend of NTN holders who file their tax returns annually. This is because people want to avoid tax deduction from their income or do not want to declare the amount of income they receive.
In order to detect income tax, tax authorities review properties and assets of an NTN holder and calculate his income. If the declared assets value is less than the actual value then there are charges on the unexplained or undeclared income of the individual. According to Amnesties, tax authorities can charge an individual for the undeclared income for not more than previous five years. If the individual pays the charges then he is not prosecuted at all. Unfortunately in Pakistan, there has never been any prosecution by the income tax department against individuals with undeclared income and assets, only penalties. Thus due to amnesty schemes, the tax network should increase as well as the tax revenue of the country. But unfortunately, neither did the tax network nor the tax revenue increased as much due to these schemes.
Another part of the tax network of Pakistan is the "money whiteners." In 1990, when Nawaz Shareef became Prime Minister, he introduced a law under the name of Economic Reform Order. This declared that if an individual opens a foreign currency account in Pakistan then the Tax authorities or the national accountability bureau cannot question its source. Along with this, they introduced a concept of foreign exchange Bearer certificates against dollars and no one can question its source as well. The purpose of these measures was that those who had undeclared income, and did not give the income tax, could convert that income into FEBCs or put them in foreign currency accounts thereafter making the money "white" or legal. A lot of these "money whiteners" were abolished at the time of Musharafs regime except for the remittances. The sources of these remittances were not questioned in his regime. This was also a way of money whitening in a way that individuals used to transfer money abroad from outside the banking channel and then that money was transferred back through the banking channel recognized as remittances.
Tax Reforms affecting Tax Collection and Compliance
According to the Economic Survey of Pakistan 2011-12, the government has placed the reform of tax administration the first agenda in order to improve the declining tax to GDP ratio along with the issues of debt servicing and defense needs. This reform strategy had three main categories; policy reforms, administration reforms and organizational reforms.
In order for these reforms to take action, according to the same survey, FBR has prepared a new recruitment policy which emphasizes on skills of the employees. This will improve the efficiency of the institution and may help increase tax effort. The main units of the Federal Bureau of Revenue namely Large taxpayers units (LTUs) and Regional Tax Offices (RTOs) will be responsible to reorganize the structure of income tax and sales tax as well as test it in order to avoid discrepancies.
Furthermore, in order to encourage individual taxpayers to comply to the income tax procedures, taxpayers education and facilitation centers has become the utmost priority of the government in order to improve voluntary compliance.
Moreover, Customs Administration reforms (CARE) were introduced in order to reduce the time of clearance of goods and reduce cost of doing business.
In addition to this, according to the Economic Survey of Pakistan 2011-12, the government has mentioned the purpose of introducing the following reforms by stating, "Reforms were made by the Government in the form of presidential ordinance and withdrawal of SRO based exemptions; amendments were made in the Sales Tax Act, 1990, Income Tax Ordinance, 2001 and Federal Excise Act, 2005."
Determinants of Tax Policy and Administration in Pakistan
Relationship between Tax Evasion and Tax effort.
Tax evasion is defined as the deliberate avoidance of an individual in paying taxes or filing tax returns to the Tax authorities. While tax effort is a conglomerate of tax administration, tax policies and laws, tax compliance and the tax base which enables an institution to have the capacity to collect tax revenue as a percentage of the income generated from that country. Therefore, the relationship between the tax evasion and the tax effort would be of negative in nature. This is because due to the increase in the trend of tax evasion by the potential taxpayers, the amount of tax collected will reduce, resulting a decrease in the tax to GDP ratio. The following graph represents data of tax evasion to GDP of Pakistan as against the ratio of Tax revenue to GDP of Pakistan from the years 1990 to 2010. The graph clearly shows the decreasing trend thus a negative relationship between tax evasion and tax revenue as a percentage of GDP.
Source: Self made. It shows the Relationship of Tax evasion as a percentage of GDP with Tax revenue as a percentage of GDP during the years 1990-2010. Data of Tax to GDP from WDI and data of Tax evasion to GDP from Kemal (2007).
Reforms and Policies in order to boost Tax Effort
There are various reforms and policies introduced by the Pakistan Government in order to increase tax collection and tax effort. Some were successful; others did not show much impact on tax revenue or the tax to GDP ratio of the country. Following are few of the major reforms are laws introduced by the Government of Pakistan and were implemented since the country's inception.
Income Tax Ordinances
There has been three major income tax ordinances passed by the government of Pakistan. Nowadays the income tax ordinance which is being observed is the 2001 income tax ordinance.
The first income tax law adopted by the Government of Pakistan was the Income tax Act in 1922.