Archive for July 27th, 2010

Last week, the NY Times released a video report by journalist Adam Ellick and a corresponding article by Sabrina Tavernise on the issue of tax evasion in Pakistan. According to Tavernise, “nationwide, fewer than a million out of 170 million Pakistanis voluntarily filed income tax returns last year. The rate is among the lowest in the world.” Below, Bilquis, a consultant from Lahore, delves into the issue of Pakistan’s tax structure:

Adam Ellick’s recent video report (see below) provides a snapshot of Pakistan’s rampant tax evasion. He reveals that to counter tax dodgers, the government has employed transgender tax collectors to collect taxes, because “residents are so embarrassed by the scene that they pay up, just to make them go away.” However, contradictory to his reporting, the Federal Board of Revenue (FBR) 10 month tax collection (2009-10) stood at Rs. 1.025 billion against the target of Rs. 1.060 billion.  A country collecting nearly 96 percent of its taxes cannot be blamed for tax evasion.  So, why is there international hullabaloo highlighting tax evasion in Pakistan?

What is not pointed out is the difference between tax evasion and avoidance. Tax evasion is not paying taxes that are legally owed, while tax avoidance is the legal utilization of the tax laws to minimize the amount of tax payable. Therefore, the reason Pakistan has such a low Tax-to-GDP ratio in the world—approx 9.5 per cent tax—is because of its tax structure that allows extensive tax avoidance.

To begin with, Pakistan’s tax structure has a narrow base that permits tax avoidance—the World Bank report (2004) states that out of the 39.1 million employed only a paltry 2.14 million (5.59 percent) pay taxes. The reasons for such low returns are:

  1. Cash transactions—transactions made in cash are not documented, making it hard for the government to identify and access income earned
  2. Informal sector—large proportion of individuals are employed in jobs that do not pay fixed wages and hence fall out of taxable net;  and
  3. Exempt income—salary allowances and privileges given to certain groups—federal and provincial government employees, the armed forces, civil servants, research organisations—exclude a large number of individuals from paying tax

Currently, the government via the FBR is attempting to introduce Value Added Tax (VAT) on goods and services—a flat rate sales tax of 15 percent. There are several advantages of VAT: it is broad-based single tax rather than the existing multi-layer General Sales Tax (GST) (between 16 to 25 percent); it is structured to collects tax in multiple stages, which will allow the government to document taxpayers, avoid double taxing and discourage the black economy.  Moreover, it replaces the current GST that has lost its spirit and effectiveness due to the numerous changes and exemptions granted through lobbying by various interest groups.

However to reduce tax avoidance, the government needs to do much more. The government must introduce an equitable tax system—tax the rich at a higher percentage than the poor as they can bear a higher burden which is essential for income parity and reform tax policies which allow deliberate tax avoidance through a penalty based system.

Unfortunately, the trouble here is a conflict of interest –the individuals who benefit from current tax policies are the people in power. If the government desired to bring in reforms, it should have included agriculture in the taxable net or at least introduced a small agricultural tax or threatened to levy a withholding tax on all the sale of cash crops like cotton, sugar, rice or wheat in the 2010-11 budget (14th June 2010, Shahid Kardar Budget seminar, Marriott Khi). However, the budget lacks any hint of equitable tax reforms and continues to benefit the elite.

Moreover, the NY Times’ Tavernise indicates that Pakistan’s elite hardly pay any taxes because of previously passed tax policies that allow for tax avoidance. She noted, “Under a 1990s law that has become one of the main tools to legalize undocumented — or illegally obtained — money made in Pakistan, authorities here are not allowed to question money transferred from abroad. Businessmen and politicians channel billions of rupees through Dubai back to Pakistan, no questions asked.” Therefore, to reduce tax avoidance, it is essential for the government to change such tax policies via a penalty based system. The Pakistani elite are not different from any other elite in the world – i.e., no one will volunteer to pay taxes unless there are negative repercussions.  Game theory dictates that as long as the personal interest (of not paying tax) of an individual is greater than the penalty, personal interest will win. Hence, blatant tax avoidance can easily be stopped by enforcing legal repercussions. Regrettably, the enforcers are the ones who benefit from such policies and prefer to maintain the repercussion free tax system. Therefore, it is hardly a surprise that Pakistan suffers from a low tax to GDP ratio.

Adam Ellick also asserts that the perpetual bailout of Pakistan from various international organizations makes it easier for the government to avoid tax reforms. Various critics stress that the international organizations must pressure Pakistan to reform its tax structure. However, because of Pakistan’s current importance in U.S. foreign policy, international organizations are reluctant to place pressure to institute comprehensive reforms.

Ultimately, bringing ‘top-down’ tax reforms in Pakistan is not an easy task and tax avoidance remains the norm.  The elite have ruled the country for decades and are more loyal to themselves than to the country.  Although international financial repercussion may bring about a change, it is only after the influx of ‘new blood’ and/or changes in the consciousness of current elite, such as Jehangir Tareen, one of the few parliamentarians to raise the issue of tax, will Pakistan get her house in order and tax avoidance will diminish.

The contribution is the sole opinion of the author and does not necessarily represent the opinion of CHUP. If you would like to contribute a piece to CHUP, please email Kalsoom at changinguppakistan[at]gmail[dot]com. Pieces should be no longer than 800 words please. For past contributions, click here.

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