The tax gap

The World Bank has recently released a report which indicates that the potential tax capacity in Pakistan currently stands at as much as 22.3 percent of the GDP. The likely tax to GDP ratio in the year which has come to an end recently is 12.5 percent. Therefore, the tax gap is as large as 9.8 percent of the GDP, equivalent to Rs 3200 billion. In other words, potential tax revenues are 78 percent larger than actual revenues. This poor fiscal effort is attributed to inadequate tax administration and non-compliance on the part of taxpayers. As such, it is an indictment not only of tax collecting agencies like FBR but also of the tax culture prevailing in the country.

There is need to ponder about how comfortable our position will be if the tax-to-GDP ratio rises to over 22 percent. The Federal and Provincial Governments combined will be generating, at present level of current expenditure and non-tax revenues, a revenue surplus of almost 9 percent of the GDP. This could then be used to more than double the level of development expenditure and generate a budget surplus on a continuing basis for the first time in the history of Pakistan. This would enable a spectacular reduction in two to three years in the public debt to GDP ratio. The jump in development spending will no doubt also accelerate the rate of growth. All this is perhaps too good to be true.

Therefore, the basic question is whether the Bank’s estimate of the tax gap is realistic or not. What factors contribute to the large gap? Can the negative determinants of the low tax-to-GDP ratio in Pakistan be limited in the foreseeable future? There is need first to understand that in the Pakistani context some of the tax gap is due to the revenue foregone as a result of tax exemptions and concessions. The political economy in the framing of tax policies provides for numerous tax privileges to the elite, to favored segments of industry and other sectors.

A study for the World Bank in 2014 revealed that the magnitude of ‘tax expenditures’ in Pakistan was as high as 4 percent of the GDP, amounting to Rs 1160 billion. Almost 62 percent of the revenue loss was due to special provisions in the income tax laws that favor the rich. For example, the highest income tax rate in Pakistan is attained at fifty times the per capita income as compared to eight to ten times in India and Bangladesh. The effective rate of taxation of unearned capital income is very low because it is largely taxed as a separate bloc of income, thereby reducing progressivity. The approach of taxing comprehensively the income of large tax payers is yet to be adopted. Other dramatic examples of favored treatment are lifetime or multiple year exemption from corporate income taxation to IPPs and other entities, virtually no taxation of agricultural incomes, low incidence of taxes on property and so on

The discriminatory treatment embodied in Schedules of the Income Tax Ordinance (ITO) and the Sales Tax Act as well as the SROs in Customs Duty is seldom highlighted. Instead, the large magnitude of tax evasion and possible collusion with the tax collector are highlighted as the principal contributors to the tax gap. According to the latest Tax Directory, only one third of the companies registered with the SECP file returns. Therefore, there is evidence of significant tax evasion in the organized sector. However, it is alleged that bulk of the tax evasion is in the big and growing informal economy of Pakistan. But it is not generally recognized that the country has one of the largest withholding/advance tax regimes, in the form of deductions at source on income, sales or expenditure.

Believe it or not, there are on last count 64 sections/sub-sections of the ITO relating to such deductions at source. Consequently, over 70 percent of income tax revenues are generated through this method and only 30 percent on the basis of returns filed by tax payers. As such, tax evasion is not as rampant as is generally perceived to be the case. In fact, there is evidence that the present regime has led to over taxation of persons with relatively small incomes. Almost 90 million persons pay income tax on their phone bills/ cards, howsoever small. 18 million are charged on their electricity bills, 41 million on interest income from bank deposits / national savings schemes and so on. As opposed to this, the number of personal taxpayers actually filing returns is hardly one million.

There is need to also recognize that different studies have revealed substantially varying estimates of the tax gap. The World Bank had commissioned research earlier on the size of the tax gap as part of the Tax Administration Reforms Project (TARP) in Pakistan. An appropriate ‘bottom-up’ approach was adopted looking at the size and distribution of income within 86 sectors of the national economy. Based on this careful approach, the tax gap was estimated at close to 6 percent of the GDP. The latest gap estimate by the Bank is almost twice this magnitude, although it concedes that the actual tax-to-GDP ratio has gone up significantly in the last few years.

The United Nations Economic and Social Commission for Asia and the Pacific (UNESCAP) in its Annual Report for 2014 has estimated the tax gap in different Asian countries by adopting a ‘top-down’ approach, which relies on use of different macroeconomic indicators to assess the tax potential. The estimated tax gap ranges from 2 percent to 9 percent of the GDP in 14 countries. UNESCAP reports a medium sized tax gap in Pakistan of about 3 percent of the GDP, inclusive of sub-national taxes. Here again the estimate is much smaller than the latest World Bank estimate.

Overall, it appears that in the next three years Pakistan can target for an overall tax-to-GDP ratio of 15 to 16 percent of the GDP. The strategy must be to make the tax system more broad-based and progressive, while avoiding over burdening any sector, especially industry. Beyond a point, higher taxation could end up stifling the growth of the private sector. The TARP project of the World Bank with the FBR is generally recognized as having had very little success. Hopefully, this time the Banks’ technical assistance will be more pragmatic and effective. The objective must be to modernize and simplify the tax system of Pakistan and work towards a nationally integrated tax administration at the Federal and Provincial levels.