This volume is a collection of original essays that attempt to shed light on tax policy in Pakistan. Some of the topics covered here have been analysed elsewhere. However, previous works have been disseminated unevenly and remained largely out of reach of policymakers and researchers interested in tax policy, in general, and tax policy and administration in Pakistan, in particular. In addition, this volume provides an in-depth technical discussion of key tax policy issues in Pakistan, thus demystifying a critical area of public policy in Pakistan.

The nine chapters in the book provide a comprehensive and systematic analysis of Pakistan’s tax system at both the federal and provincial levels. The rest of this chapter provides a general overview of Pakistan’s tax system. Besides trying to explain the underperformance in revenue collection relative to GDP we also examine Pakistan’s revenue buoyancy and stability over time. The evaluation takes stock of the recent performance of Pakistan’s tax system against other important objectives of the tax system. Some of these issues are then treated, in detail, in the remaining chapters.

In this chapter, we review the current tax structure and discuss some of its most important flaws. The structure of Pakistan’s tax system and therefore, its revenue capacity, economic neutrality, and fiscal equity, have been hobbled by continued practice of ad hoc policy measures narrowing tax bases of major taxes. Any serious tax reform in Pakistan will include exploring the feasibility of comprehensive tax reform to arrive at a more coherent, simpler, and more elastic tax system. To serve this end, we will review the process of tax policy formulation. Chapter 1 concludes with the way forward and recommendations for the short term and the medium term.

In the following chapters of the book, we present a wide ranging discussion of tax policy issues in Pakistan.

Taking a broader look at the strengths and weaknesses of Pakistan’s taxation system

Chapter 2, written by Wayne Thirsk, undertakes a critical evaluation of the strengths and weaknesses of all of Pakistan’s major sources of tax revenue: individual income tax, corporate income tax, sales tax, excise taxes, and trade taxes on imports. The public finances of Pakistan’s federal government rely on five major sources of tax revenue: (1) income tax on individuals and associations of persons, (2) corporate income tax, (3) sales tax, (4) excise, and (5) customs duties. Chapter 2 examines in some detail the contents of the tax laws that, together with the current tax administration apparatus, govern how each of these revenue sources operate to generate revenue as well as the impact they have on the distribution of tax burdens in the economy and the allocation of resources to different economic activities. For each major tax, Chapter 2 describes the nature of the current tax base and the rate or rate structure that is applied to that base. Certain features of each tax that raise significant concerns for tax policy and constitute the beginning of an agenda for future tax reform are discussed next. In each case, the tax policy issues that has been flagged are discussed within a policy framework that appeals to the broadly accepted norms of ‘good’ taxation and international experience in grappling with these issues. The chapter concludes by setting forth for consideration an array of tax reform proposals that attempt to address the most important flaws and problems that have been detected in Pakistan’s tax system.

Pakistan’s current individual income tax is complicated. It operates with two basic schedules for recipients of wage and non-wage or business income, each having different zero rate brackets, with anywhere from 14 to 21 different tax brackets. The individual income tax suffers from major tax evasion and yields little revenue. It applies high marginal tax rates to the total amount of a taxpayer’s income. The notch problem can result in punitively high effective rate of marginal taxation and create perverse incentives to accurately report additional amounts of taxable income. The individual income tax contains far too many tax exemptions and concessionary rates. The basic design features of the corporate income tax matches well against standard international practice, but two important problems remain. One problem is the poor compliance that is observed for this tax so that even a good tax on paper can cause significant distortions in resource allocation and have inequitable effects if not implemented effectively. The other problem arises from the tax treatment of small corporations, and in this case, there are two major issues. One issue is the failure to tax small corporations’ taxable income in an incremental manner and to subsequently target the benefits of the lower tax rate on small corporations to only small companies. Under current treatment, a small corporation that grows beyond the turnover threshold for a small business faces a confiscatory tax regime. The second issue is the exemption of small corporations from any withholding obligations and the damage this exemption can inflict on the entire system of tax withholding.

Sales tax, another major source of revenue, has a registration threshold that is relatively high in comparison with the choices made in other countries. The current Sales Tax Act has some legal gaps and lapses and allows the Federal Board of Revenue to determine how the tax is to be applied. This legal discretion has resulted in marked instability as to how this tax has functioned. Excise taxation has become relatively less significant over time. In its structure, an excessively large number of different rates apply to petroleum products and their derivatives. A few of the excise tax exemptions opened the door to wide-scale tax evasion. Pakistan has not considered the scope that exists for applying ‘green’ excise taxes.

James Alm and Mir Ahmad Khan, in Chapter 3, analyse the efficiency effects of corporate income tax. The system of taxing enterprises has undergone some major changes in recent years. Nevertheless, the corporate tax system remains plagued by a number of problems. One problem is the existence of numerous exemption programmes that have significantly reduced tax revenues, and greatly distorted the allocation of investment across sectors and asset types. There also seem to exist significant levels of tax evasion, evasion that also distorts resource allocation, reduces tax revenues, and compromises the distributional objectives of the system. The tax base has been shrinking over time, partly as a result of tax avoidance and tax evasion further reducing revenues and sometimes leaving the more visible taxpayers still out of the tax net. The extensive use of tax incentives is not tracked, quantified, and evaluated. And the intended effects on economic growth are uncertain. The tax incentives are only one feature of the tax system that contributes to an overly complicated system. These complications illustrate the limitations of the tax administration. The basic structure of the tax system was designed for times and circumstances that have long passed. The tax system has evolved over time in an ad hoc manner with little apparent thought given to the ways in which the pieces of the system need to fit together. Chapter 3 examines these issues, which relate to the yield, the neutrality, the progressivity, and the simplicity of the system of tax enterprises.

A serious problem with the system of enterprise taxation relates to the distortions in investment across sectors and across assets within a sector. A commonly accepted notion about ‘good’ tax policy holds that the tax system should raise revenues with minimal interference by the decisions of consumers and firms. When a tax leads individuals and businesses to change their decisions solely because of the existence of the tax, the tax is said to impose an efficiency cost, or an ‘excess burden’. One of the major sources of these distortions is the relatively heavy reliance on tax incentives and exemptions in Pakistan. The authors present a calculation of Marginal Effective Tax Rates (METR) by asset type to clearly show that assets are treated quite differently by the various features of the tax system. The large variations in METR distort marginal investment decisions across assets and generate efficiency losses. These differences are driven by the same features of the tax code. Comparisons with international cases show that METR in Pakistan are often higher than in several other countries, but the differences are not very wide. The METR for these international comparisons do not reflect the reductions in statutory corporate tax rates in many of these countries in recent years. This means that the actual prevailing differences between Pakistan and other countries are likely to be considerably higher than suggested by the comparisons.

Geerten M.M. Michielse, in Chapter 4, discusses the tax treatment of Pakistan’s international tax practice. In particular, Chapter 4 deals with the international aspects of the tax system: (a) the double tax agreements, and (b) the trade agreements. The Income Tax Ordinance of 2001, the currently in vogue legislation, contains a number of provisions dealing with international issues of the domestic tax system. They lay the basis for the protection of the domestic tax base. In addition, Pakistan has concluded over 50 double tax agreements which complement these domestic rules. The total system in place is to a large extent in line with international practice. However, due to economic globalisation, some flaws in the international tax system have occurred over the last two decades. Not only is Pakistan facing these practical difficulties, other countries do too, yet there are no readily available solutions available.

The above excerpt is taken from the chapter ‘Pakistan’s Enduring Agenda for Tax Reforms’.

Excerpted with permission from
The Role of Taxation in Pakistan’s Revival
Edited by Jorge Martinez-Vazquez and Musharraf Rasool Cyan
Oxford University Press
ISBN 978-0199401154
700pp.

Published in Dawn, Books & Authors, May 29th, 2016