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Income Tax: is there any shortcut to correction? – III

Part I and II of this series summarized the underlying tone of the fiscal framework adopted in the last 50 years in Pakistan. Except for some non-substantive and minor aberrations, the system throughout the period has been geared and designed for:

(i) Generating ‘Guaranteed Revenue’ for the government. It is appropriate to state that ‘finances’, not taxes, were arranged as whilst doing so all the principles of public finance and taxation were totally overridden and ignored; and

(ii) Facilitation of ‘import led consumerism’ duly supported by ‘encouragement of non-documentation’, at the cost of organized domestic manufacturing industry;

These two underlying tones temporarily filled the ‘financial holes’ for all the governments on year to year basis. Resultantly after decades, the country ended up in financial and economic crises. 2018 is no different. There had been an average GDP growth rate of 3 to 5 percent over these years. This GDP growth rate which in itself represents a low percentage for developing country’s standard, is largely import based/consumption oriented. As against the correct situation, many false and irrelevant instances are quoted to demonstrate growth. An example of such illusionary progress readily available at recent times, is that as many as 40 million Pakistanis are using ‘cell phones’. This consumption pattern is correct however the fundamental question is whether or not the use of imported (sometime smuggled) cell phones can in any manner demonstrate a pattern or sign for a sustainable growth trajectory. There are many other such false and deceiving examples. At times the common man gets confused by such data. In the author’s view, Pakistan has not really progressed in the last fifty years (1970 to 2018) in any meaningful sense if we take the sustainable fiscal framework into consideration. In the following paragraphs, it will be identified that Pakistan’s fundamental fiscal structure is defective. It is so by design. This has been illustrated in the first part of the article. Fiscal system is further deteriorating on account of (a) overwhelming stress on withholding/collection of taxes and (b) loss of government writ over untaxed/undocumented economy. These are two fundamental indicators of present state of affairs.

It will be evident from what follows that with the present fiscal framework Pakistan is not geared for sustainable development of manufacturing sector. Therefore, this framework will not enable reasonable and productive ’employment’ opportunities for our youth that accounts for over 40 percent of our population. As a country, we cannot afford that.

There cannot be sustainable increase in ’employment’ opportunity unless there is reasonable/sustainable increase/support for the ‘domestic manufacturing industry’. The situation at present is working in reverse order. In Pakistan, there is an ‘uneven playing field’ for domestic manufacturing industry against import/consumption-based mindset. Many people may not agree fully with this simplistic approach/conclusion about the causes of present and persistent crises on economic matters. However in the author’s view, which is based on over ‘thirty years’ of practical experience in trade and commerce, the problem is ‘self-inflicted’ and the root cause is ignoring domestic manufacturing industry resulting in decreasing employment opportunities. Within this wide subject, articles in this series are restricted to fiscal policy and administration aspects only.

Fundamental defects in fiscal side even at the cost of repetition from Part I, are summarized below for the purposes of providing continuity to the discussion are:

Reliance on Withholding Taxes: Since 1960 to 2018, there has been a gradual increase in reliance on withholding/collection of taxes instead of recovery on net income basis. Now around 70 to 80 percent of the collection is made on withholding/collection of tax at source. Almost all receipts/payments/withdrawals etc are subject to withholding/collection of tax at source. At present Pakistan’s fiscal code consists of over 70 heads for withholding/collection of tax at source. It is not an administrative error. It has become an undesirable necessity for every government especially after 1990s to rely on guaranteed revenue from withholding and collection of taxes at source.

Abolition of Effective Direct Taxes: In 1992, withholding and collection of tax at source was converted into ‘presumptive tax regime’. Resultantly, direct taxes were effectively abolished and indirect taxes were ‘guised’ as direct taxes. In all societies withholding / collection of taxes at source is only a ‘tax collection’ mechanism. Taxes withheld or collected are adjustable against ‘income’ ultimately determined. Any excess collected is refunded. Presumptive form of taxes, are wrong, absurd and unconstitutional as this system that has overridden all forms of direct taxation. There is no possibility of any income/wealth distribution equity in society as long as these kinds of taxation measures exist. Under presumptive tax system there is no requirement to determine income or maintain any form of ‘documentation’. This means that Pakistan as a country legislated that there is no requirement, except for corporate sector, to maintain any form of ‘document’ or pay taxes on ‘net income basis’.

Incorrect Foreign Exchange Regime: Protection of Economic Reform Act, 1992 and similar legislations provided legal means to transfer taxed and untaxed wealth outside Pakistan under legal cover;

Numerous Legally Permissible Parking Lots for Untaxed Funds: Adequate avenues have been provided to park untaxed money in Pakistan. Defective mode and manner of valuation of immovable properties; bearer securities, no restriction on the hoarding of foreign currencies, and introduction of high denomination currency notes are glaring examples of such aberrations;

Non-Level Playing Field For Domestic Manufacturing Industry: Medium and large sized domestic manufacturing industry has been discriminated against undocumented trade sectors, in all fiscal policies and regulations. Effective composite rate of taxes on such industries, if documented, is over 50 percent. This includes taxes on income, taxes on dividends etc as against an incidence equal to 5 to 20 percent for non- industrial sector. In the post 1970 period Pakistan has effectively been ‘de-corporatized’ and ‘de-industrialized’. In short, it is not a fiscal issue. It is an economic issue, driven by incorrect tax policies.

Objectives of Import Based Economy and Discriminative Taxation Regime: The author firmly believes that these actions are the result of a policy framework. It is not an error. It may be an error only to the extent that negative aspects of the results could not have been accurately perceived when such framework was being designed. There were political expediencies to adopt this approach. There had never been a government in power, including martial law regimes, that was able to resist the dual pressure of having ‘guaranteed revenue’ and happy ‘trading’ sectors especially those dealing in imported products. Maintaining status quo with cosmetic changes suited all governments in power. For example, import of petroleum products is easy source of revenue for government, it encourages heavy transport industry and satisfies the ‘Sher Shah Surian’ desire to make ‘motorways’. However, current account problems and cheap transportation of exportable surplus can only sustainably be achieved by revitalizing ‘railways’. This dimension has always been ignored. There can be many such examples of policies that have destroyed the primary fabric of the economy of the country.

On the fiscal and tax collection front the ‘State of Pakistan’, under all regimes in the last 40 to 50 years is gradually retreating on tax side. In a disguised manner the state is losing its ‘writ’ to rule for not being able to collect taxes where due and from whom they are due. Financial requirements of the government are fulfilled by placing un-justified guised and disguised indirect taxes on poor and middle classes. This creates distributional inequity.

Now, in 2018, the question is whether there can be any attempt to stop this retreat and bring equity in the system. In the author’s personal view, this issue is effectively related to fragile economic conditions that the state of Pakistan is facing since inception and September 2018 is no different. We are standing in a queue to beg or borrow. Every time, is the last time for us. However, that last time does not arrive.

There is a need to have a proper and independent review of past actions to let the people know that Pakistan has not changed for the last fifty plus years. This will not be an attempt to create hopelessness in society but will bring a reality check for the people to revitalize their energies.

The message that has to be sent across to the masses is that there is no shortcut, short-term solution to rectify the culture nourished in the last 70 years out of which last 50 years were a disaster as far as ‘economic planning’ is concerned especially on fiscal and trade related issues.

In the following paragraphs, some practical solutions will be highlighted as a ‘transitional measure’ to be followed by a medium and long-term strategy. The message for the masses is that there should not be any expectation of well-being in the short run. Nevertheless, at this stage, it can be demonstrated that a right path that is sustainable has been adopted.

The only test for any progressive government will be to rely on people of Pakistan’s resilience against that ‘guaranteed revenue’ and ’tilt against imports based growth’ which many people in Islamabad including the bureaucracy will very strongly desire to maintain for the reason that the same provides unnatural short term comfort zone. It acts like a painkiller for a patient suffering from serious infection or a fatal disease.

As stated earlier, that almost all the policy decisions on fiscal side for a very long time did not provide sustainable growth pattern for the economy, however, such actions were ‘intensified’ by certain step undertaken after 1992 under the guise of ‘economic reform’ to create a false sense of prosperity by increasing ‘imported consumption based economy’ for political reasons. This is a very long debate however the ultimate result is enough to demonstrate the severity of mistake. Our local and foreign debts are two apparent results of these wrong policies. On the foreign side, Pakistan owes around USD 90 billion to overseas creditors whereas Pakistanis own an estimated 100 billion USD assets abroad. During the period 1992 to 2018 there were legally recognizable ways for Pakistanis to park their assets legally outside Pakistan. In the author’s view there is nothing wrong in placement of personal assets outside Pakistan. However our tragedy had been the ‘institutionalization’ of a system where untaxed/undocumented funds were allowed, (actually encouraged) to be parked outside Pakistan through legally protected mechanism. This aspect has been discussed in detail in the author’s book Rich People: Poor Country which is the compilation of articles printed on this subject in this esteemed paper during 2017-2018.

Present Tax Culture-Non-corporate business: As a result of the fiscal policies adopted in around past 50 years a unique and distinct culture has emerged for non-corporate businesses. It is essential to identify the main features of that culture in order to identify corrective efforts. The pertinent component/features of that business culture are:

1. There are at least around 30 to 35 million small and medium size businesses, both in manufacturing and services sectors in Pakistan, scattered all around that are virtually outside the ‘taxation system’ in the sense that there is no tax on such businesses on ‘net income’ basis;

2. On the services side, the situation is even more deplorable. For example we find very few ‘doctors’ or lawyers in private practice who provide documentation of income earned etc;

3. A small part of such businesses, which number around half a million persons/organizations are already under tax system as they possess National Tax Number (NTN). However, the amount of taxes paid under these NTN’s is exceptionally low and nominal. This represents a case of prevalence of ‘under-declaration’ and not ‘non-declaration’. Generally, such businesses are run under sole proprietorship or partnership. The author is aware of a large market dealing with unstitched ladies clothing where the maximum tax paid by any shop was less than Rs 100,000 a year;

4. The Federal Board of Revenue or any other agency does not have any proper market or shop-wise record of such businesses. This happens despite the facts that jurisdictions within the tax offices are location centric especially for small and medium sized businesses. In the past, there used to be a ‘survey and collation’ department within FBR for gathering data of such businesses however it has been temporarily restrained from doing any work as that process was leading to nothing but harassment. There is a complete erosion of writ of state in this sector. The first task is creation of a ‘data bank’.

5. Such businesses are not required, under any provision to maintain any kind of ‘books of accounts’; and in most of the cases the ‘owners’ and ‘operators’ are not sufficiently educated or trained to maintain ‘books of accounts’ to determine net income. The problem has been intensified for the reason that all kinds of formal requirement to maintain books of accounts has been abolished in the last 30 to 40 years. So ordinary businesspeople are not used to it. In almost all the developing and developed countries, small and medium sized businesses maintain certain minimum accounts that are able to ascertain estimated net income and there recognized professional bodies available to interact between the tax collector and taxpayer for bridging the competence gap and comprehension.

The cultural aspects identified above, need to be changed if such businesses are to be brought within the documented tax sector. At present these businesses are effectively out of the system. There can be various reasons for the same however in the following paragraphs it has been demonstrated with the help of illustrations the reasons and basis of this exclusion. As stated earlier it is fundamentally a policy error that has been compounded by administrative inefficiencies.

Typical culture of a non-corporate business The prevalent business culture of non-corporate sector can be appropriately analyzed if we study the dynamics of a medium and small size trader in any market in Pakistan. For example, in case of a trader dealing in auto spare parts or any FMCG goods the situation is usually as under:

These shops and business are filled with following diversified kinds of products:

1. Local products purchased from organized and documented sectors such as cements, FMCG. These are all documented for the reasons that ‘supplier’ is a documented Pakistani manufacturer. This is compulsive documentation;

2. Local products purchased from unorganized and undocumented manufacturing sector. These products are acquired from manufacturing units and entities which are either undocumented or where the incidence of undocumented production is substantial;

3. Imported products-invoiced at correct prices;

4. Imported products-invoiced at an undervalued basis;

5. Smuggled and Afghan transit products.

Bulk of sales are made in ‘cash’ directly to consumers and there is no desire for an invoice by the buyers.

Such businessmen have documents of purchase for items acquired as referred to in (1) and (3) only being purchases from the documented manufacturing sector or imports at correct prices. For (2), (4) and (5) there is no presentable purchase document. This is the main issue and starting point of the process of non-documentation.

Business Culture and Tax Policy: The business culture, as identified above, is not something ‘unknown’ to policy makers. Tax policy measures referred to in the aforesaid paragraphs have been designed to adhere to these practices. Products acquired under the head (1) and (4) above have been placed under presumptive tax regime. This means that responsibility of record keeping and documentation, as policy has been limited to organized manufacturing or import stage and the subsequent secondary businesses in the chain (traders) have been excluded from any form of documentation.

We can now relate this culture with the policy actions discussed in earlier parts of articles in this series. As indicated earlier the state gradually receded in its writ on taxation matters. At the first stage, an incorrect self-assessment was designed where the income was deemed to be equal to 20 percent more than last year. Then it was ultimately decided that even that cosmetic presentation is not required. What is withheld by the manufacturer or collected by the importer is deemed to be the final liability. This was Presumptive Tax Regime.

When businesses realized that there will not be any determination of net income and the state receded on documentation the composition of total inventory they dealt with started changing. Products acquired from (2), (3) and (5) gradually over shadowed the documented sector. This process was further facilitated by incorrect foreign exchange reforms. Previously it was 30:70 now it is 70:30.

Now, if we do a survey of ‘markets’ for any kind of product then it transpires that in many cases the shops are filled with products acquired from undocumented manufacturing sector, under-invoiced imports and smuggled and Afghan Transit products. In an economy where services sector being retail and wholesale trade consist of around 15 to 20 percent of GDP of around USD 350 billion there cannot be any possibility of sustainable correction unless there are fundamental changes both in business culture and tax policy. Administration is a secondary aspect.

Choices for Business People: In this situation, the question for a businessman is whether or not he/she can operate in a cultured documented environment if he/she is engaged in trade. The unfortunate and difficult answer is in negative. There is no possibility of acquiring verifiable presentable documentation for bulk of purchases therefore there is no question for any documentation for ultimate sale and resultant profit. This is a business culture issue that has nothing to do with running any particular trade. It is not possible to deal only in ‘documented sector’ or ‘correctly priced imports’. If somebody does the same then he or she will be out of business soon. These ground realities had been accepted earlier and are the result of collapse of our overall governance structure. In short, wrong tax system as explained above has led to the aforesaid ground realities.

Analysis of Ground Realities: Analysis of the aforesaid ground realities, read with the contents of Part 1 of these articles reveal that the state has lost its ‘writ’ in having a possibility of recovering its due share of tax on profit of such businesses. At the same time even if some reasonable businessmen intend to operate in an organized documented manner then the same is not culturally and practically possible for them.

In this situation, it is virtually impossible for such ‘retailers’ to determine net income, which is acceptable to tax department and pay tax on it. It is not the matter of rate of tax payable. Even if the said rate is 5 percent, the market mechanism as referred above does not allow the retailers to determine tax on the net income basis. The status as referred above is true for almost all kinds of trading in products.

As a result of these problems, in effect, tax on presumptive or net income basis is paid only on the goods acquired from registered large scale manufacturers and those imported at correct price. The retail shops all over the country and one around the corner of my street will be paying taxes on products acquired from Nestle, Lever, Engro, P&G, etc, as a compulsion as the said record is available from other end. However, such shops are absolved from tax on profits made on sale of products acquired from unregistered manufacturer, smuggled products, under-invoiced imported products etc. That is where there is huge profit with direct and indirect burden on our current account balance.

Not Only A Tax Problem: The matter discussed above has multiple dimensions for the economy. An in-depth analysis of this issue reveals that composition of imported products and that too at under-invoiced amount is gradually increasing. This has directly inflicted serious wounds to our organized documented manufacturing sectors that ultimately bear the incidence of taxes. In the second part of articles on this series the author will concentrate on measures to increase domestic manufacturing, exportable surplus and decrease in consumer oriented exports.

Distributional Equilibrium: Fiscal Policies: There is a serious social angle to fiscal policy mismanagement also. Persons not engaged in non-corporate sector business of trading and service sector such as ‘salaried classes’ and ‘general masses’ including middle class farmers are not able to compete socially with the gulf that has arisen on account of the difference in the ‘disposable income’ in the hands of an ordinary traders / retailers in comparison to other professions such as say a ‘College Lecturer’. The first category as explained earlier is by law excluded from any form of direct taxes on their net income.

Being a country of 200 people, there is substantial demand for goods and services which are all routed through such businesses. Around USD 30 billion worth of goods and services (say: 50 percent of total imports) filter in the economy of the country. They end up in retail and wholesale markets. This amount excludes trade in under-invoiced, smuggled and Afghan Transit Trade goods. Business in such products results in substantial ‘disposable income’ without any effective contribution to exchequer for people directly or indirectly engaged in such activities. There are hundreds of persons dealing in genuinely imported or smuggled mobile phones who earn much more than qualified people like College Lecturer. For example, a qualified MBBS is barely able to get a pay of Rs 50,000 to Rs 70,000 whereas an ordinary retailer/dealer of imported products, even imported fruits, can easily have a disposable income of over Rs 250,000. In the similar manner, an ordinary agriculturist having 15 to 20 acres of land is barely able to have a disposal income of Rs 30,000 to 50,000 a month whereas the person acting as ‘arthi’ or ‘commission agent’ of agricultural products in ‘mandis’ earn very substantial income without any contribution to exchequer. There cannot be sustainable development in society with such irrational differences in income distribution and contribution to national exchequer.

The answer and bottom line to this discussion is revival of documentation of economy. Any attempt to directly target market and people will be highly destructive and non-sustainable. Pakistan as a country requires a will at the parliament level that there is a need for ‘documentation of economy’. Once that process is on, other problems will be resolved in the natural course. The areas, where there is urgent need for action, will be identified in the next part.

Syed Shabbar Zaidi, "Income Tax: is there any shortcut to correction? – III," Business Recorder. 2018-09-03.
Keywords: Auto spare parts , Guaranteed Revenue , Business Culture , Competence gap , Employment opportunities , Correct price , Account balance , Fiscal policies , Tax policy , GDP , USD