Like its counterparts in other developing countries, the government of Pakistan finances a major portion of its budget through tax revenue. But tax collection as a percentage of gross domestic product (GDP) is considerably small compared with similar economies. This is due to tax expenditures, which are special provisions in the tax code, such as exemptions, special schemes, reduced rates and other deviations from international standards in the tax statutes.

Revenue losses due to these expenditures during 2017-18 were estimated at Rs541 billion, 14 per cent of the total federal tax collection. This leads to the questions about the effects of tax exemptions and concessions on the economy and their main beneficiaries.

An apparent disadvantage of a tax policy encompassing exemptions and concessions is that it squeezes the base and shifts the burden on to a smaller number of existing taxpayers to compensate for the loss of revenue. The effective rate of taxation on unearned capital income is very low in the country. Income distribution is also highly skewed as taxation is ineffective as far as high net worth individuals are concerned.

Revenue losses caused by special provisions in the tax code in 2017-18 were estimated at Rs541bn, 14pc of total federal tax collection

With overwhelming reliance on indirect taxes as a major source of revenue (they constitute more than 62pc of overall collection), the system can be termed neither fair nor equitable.

Of direct collection, an overwhelming portion of revenue is being collected under the presumptive regime due to extremely low voluntary compliance and a large tax gap, which is the difference between anticipated and actual collection. It is no denying the fact that presumptive taxes are the ultimate form of indirect taxes. Hence, actual collection from indirect taxes is a lot more than the official rate of 62pc.

Exemptions, concessions and other deviations from standard tax policy put a question mark on fiscal transparency, an important feature of good governance. To establish fiscal transparency, the structure and functions of the government, policy intentions, public-sector accounts and projections must be open to the public. Although the inclusion of tax expenditures in the budget is a basic requirement of transparency, the government has been publishing only estimates in its economic surveys since 2006-07.

Tax systems that are riddled with exemptions and concessions and targeted towards certain individuals and economic sectors lack neutrality and tend to disrupt the market mechanism by misallocating resources.

This can be one of the reasons for the extremely narrow tax base and widespread non-compliance. For the sake of maintaining structural simplicity and ensuring legal certainty, tax systems should be broad and comprehensive.

An apparent disadvantage is that it squeezes the base and shifts the burden on to a smaller number of existing taxpayers to compensate for the loss of revenue

Since these expenditures add complexity to the tax system and tend to increase compliance costs and risks for businesses, exemptions and concessions have an adverse effect on it as a whole. This is the reason the tax burden in terms of maintaining business records, preparing and filing returns, paying taxes and complying with other administrative obligations is comparatively high in Pakistan. Undoubtedly, the cost of doing business affects investment and economic growth. Businesses are inclined to migrate to the informal sector when the cost of doing business gets high.

Last but not least, the fiscal policy of tax expenditures influences the income level and well-being of different population segments. Tax expenditures appear to be an important source of income inequalities. It is being recognised that whopping exemptions introduced in the past few years have benefited only a select group of influential people.

In short, broad exemptions and extensive privileges complicate the tax system, increase the cost of collection and open up windows for evasion. Since Pakistan has a considerable budget deficit of 6.8pc and a low tax-to-GDP ratio of 12.5pc, it urgently needs to improve its financing situation. As tax expenditures erode the base and reduce overall revenues, eliminating ineffective exemptions will help increase the tax-to-GDP ratio. The elimination of exemptions relating to indirect taxes that are to the exclusive benefit of inefficient but politically powerful segments will help make the taxation system fairer and equitable.

Only those tax expenditures that can be instrumental in promoting economic growth, infrastructure, education, health care and poverty reduction should be allowed.

Besides, policymakers must review the issue of tax refunds, which are riddled with malpractices. Not all claims of refunds are necessarily genuine. Some refunds are being claimed on fake invoices. Similarly, not all genuine refunds are being processed by tax authorities in time. Denying or delaying the processing of genuine refunds is against the self-assessment scheme.

The writer serves as additional director of intelligence and investigation at the Federal Board of Revenue.
bilalhassan70@yahoo.com

Published in Dawn, The Business and Finance Weekly, September 3rd, 2018