Recouping tax losses

Successive governments in Pakistan - civil and military alike - have demonstrated criminal apathy and negligence in promoting tax evasion and flight of capital from Pakistan. It was legalised by the government of Nawaz Sharif with the dollarization of the economy through the so-called Protection of Economic Reforms Act, 1992. This law gave free hand to the tax cheats and money launderers to get billions whitened. Unfortunately, this law has never been examined by anybody from this perspective.
All the public office holders who have taken advantage of this law to avoid tax should have been disqualified for open admission of cheating the State. But not a single case has been filed till today. This shows how the rulers in this country engineer laws for self-aggrandisement. The losers are the poor and the helpless of this Land of the Pure, who are burdened with exorbitant indirect taxes and yet get nothing in return. The rich and mighty enjoy all the luxuries of life at the taxpayers' money, whereas nearly 60% population is living under the poverty line.
That there is a considerable informal economy, revenue leakages and black money in Pakistan is not doubted but few in-depth studies have been undertaken to quantify its magnitude and extent. A sound development strategy seeks to reduce the size of the informal economy and bring into the open resources that lie in the form of black money. Apart from such mechanisms as foreign exchange and tax amnesties; and exercises such as demonetisations, taxation has been used as a tool to tap the resources inherent in these areas. Our politicians, policymakers and tax managers during the last many years have miserably failed to tap such untaxed resources despite borrowing US $100 million under the Tax Administration Reforms Programme (TARP). The fact is that the policies framed under the TARP have proved counterproductive as billions of rupees are transferred by the people from Pakistan abroad.
Those at the helm of affairs in the Federal Board of Revenue (FBR), are making tall claims of achieving "extraordinary results" and getting cash rewards for giving shelter to tax evaders. The actual tax potential is between Rs 6-8 trillion, but they do not collect even one third of it. The persistent failure of our financial managers and tax collectors to overcome the fiscal deficit has created a situation where the very economic survival of the country is at stake.
The FBR, according to all available data and indicators, is inefficient, incompetent and corrupt. The FBR, responsible for the collection of federal taxes, has miserably failed to introduce any tax-intelligent system, despite the fact that it has a market-waged company, the Pakistan Revenue Automation Limited (PRAL), at its disposal. It is reported in the press that as on January 31, 2012, there was a 42% decline in tax filings, raising a big question mark about the much-publicised drumbeating by the FBR that nearly one million new taxpayers have been brought under the tax net. The failure of the FBR can be measured from the fact that only 16,783 corporate returns were filed this year as against 19,331 returns last year. Total numbers of registered companies as on 30.06.2010 were 56,120 (about 200 companies are registered every month). It is pertinent to mention that under the Income Tax Ordinance, 2001 all companies are obliged to file tax returns. If the FBR cannot compel about 56,000 companies to file tax returns, how can it enforce the law for filing of returns for the millions who own cars and pay telephone bills. Making such laws and then failure to enforce the same is our real dilemma.
This failure, coupled with rampant corrupt practices prevalent in the country, that has contributed to the generation of enormous black money in Pakistan as elsewhere. Many countries of the world have recently forced the Swiss banks to give information of tax cheats. The Swiss Finance Minister, Eveline Widmer-Schlumpf, has recently informed a parliamentary economics commission that Credit Suisse and seven other Swiss banks wanted to make concessions to the United States by offering information about client relations.
According to research by the German-language public radio station, DRS, the data offered includes communication between bank advisors and their clients. Four to six million emails are reported to be involved. Switzerland is in the process of negotiating a tax agreement with the US to address the problem of US tax evaders hiding money in Switzerland. The negotiations have stalled because the US, which wants a fine in the billions, is demanding to see more bank client data. Most recently, Widmer-Schlumpf said after meeting US Treasury Secretary, Tim Geithner, in Davos that a deal to end the tax evasion row with the US could come later this year. Our government has not yet even started the process of entering any such treaty with Switzerland.
Large-scale tax evasion and the existence of a large black economy while resulting in loss of revenue to the state, tends to reduce the built-in elasticity of a fiscal system to the extent that the tax evaded income is spent on goods and services that help to generate inflationary pressures and raise the prices of real property. A survey, carried out by a reputed Lahore-based academic institution a few years back, as a part of tax reformation drive, concluded that mainly because of rampant corruption, in combination with a host of other factors, "the country suffers a loss of 64 percent in income tax, 48 percent in customs and 45 percent in sales tax". Translated into hard cash, this means that for each hundred rupees of genuine income tax payments of a typical Pakistani business, the government collects only Rs 36. "The rest of the money is shared among the three parties - assessor (taxman), the assessee (taxpayer) and the middleman (tax practitioner).
According to this study, out of every Rs 100 taxable amount, the highest amount of Rs 38, of course, goes to the taxpayer, a typical Pakistani businessman. The taxman, an officer in the income tax department, gets Rs 16 for his services to the taxpayer in helping him to conceal his real income. The middleman who is a tax practitioner, advisor or a lawyer gets Rs 10. If these estimates are taken as true, then the revenue loss for the fiscal year 2009-10 cannot be less than Rs 400 billion. These estimates are summary judgements of a complex phenomenon. The survey concedes that these estimates may not capture part of the revenue loss due to the presence of a large, unregistered business segment, on the one hand, and smuggling on the other.
It is not possible to predict the precise amount of revenue loss and size of black money or informal economy in Pakistan. The report prepared by the LUMS, nonetheless, claims that the data collected during the survey "is pointing to a very heavy leakage". Another report estimates revenue loss, because of distortionary tax regulations and administrations, at Rs 40 to Rs 45 billion in 2008-09 and Rs 74 billion in 2009-10. Apart from direct monetary costs of corruption, both Pakistani and international literature pinpoint many other costs, such as loss of government credibility, spread of injustice, distortions in resource allocations and loss of foreign and local investment.
Dr Aqdas Ali Kazmi in his paper Tax Policy and Resource Mobilisation in Pakistan estimates that 70 percent part of economy consists of 36 percent 'pure' black economy, 18 percent exempted economy, 9 percent illegal economy, 4.5 percent unrecorded economy and 2.5 percent informal economy (unreported economy). His study says that the problem in the low resource mobilisation is the rigid system of taxation, and the emphasis of the government to increase revenue, ignoring the details of the long-term policy measures.
The recurrent appearance of amnesty schemes and money-whitening instruments and modes shows that the State has conceded the failure of its tax machinery in performing its main function of collection of taxes. The policies of the corrupting State has forced the nation to become addicted to easy money as such schemes and instruments have become a routine matter for them. The latest one is the promise by Dr Hafeez Shaikh to stock markets that money invested in scrips would not be questioned till June 30, 2014.
The people hooked on ill-gotten wealth/income for the last many years know for certain that after every two or three years, there will be an amnesty scheme giving them a chance to get their income/assets whitened by paying far less the amount than what they were required to pay under the normal income tax/wealth tax regime or they can always take benefit of section 111(4) of the Income Tax Ordinance, 2001. This section says that no question will be asked about the source of funds brought into Pakistan through normal banking channels. You have just to go to a money exchange dealer and he will arrange "remittance" for you by taking money plus a small premium. It is a tragic situation where the entire state apparatus is subservient to those who blatantly manage to hide their income and wealth. It is an ugly joke with those who have been paying their taxes honestly at much higher rates than those offered to tax evaders (ranging between 2% to 10%) under such Schemes.
One of the worst consequences of black money and tax evasion is their pernicious effect on the general moral fabric of society. They put integrity at a discount and place a premium on vulgar and ostentatious display of wealth. This shatters the faith of the common man in the dignity of honest labour and virtuous living. It is, therefore, no exaggeration to say that ill-gotten wealth is like a cancerous growth in the country's economy, which if not checked in time, is certain to culminate in its death.
The internationally recognised definition of the underground economy is: all types of economic activities, which are beyond the control of the tax administration and other government departments, and from which outputs and incomes fail to be brought into the GDP computed by the government.
The most common classification of the underground economy is mainly from the standpoint of taxation, dividing it into the following two areas:
-- Economic conduct whose operation is illegal eg smuggling; and;
-- An economic activity whose operation is legal or does not go against the laws but where the income derived is not reported to the government and is not subjected to tax.
Pakistan is not the only country in the world that is facing the problem of colossal loss of revenue due to the underground economy. It is a world-wide problem. In, Russia and Eastern European countries, this malady once destroyed the entire social fabric, besides causing heavy losses of tax revenue. In Asian, African and Latin American countries, the issue of the underground economy is extremely serious, and particularly such activities as smuggling, drug trafficking, money laundering and bribery have attained a considerable size. Even in the developed world with strong and developed legal and tax systems and highly efficient governments, underground economic activities cannot be taken lightly.
Why has the Pakistani underground economy evolved so rapidly since 1977? This question baffles every concerned citizen; however, there is no adequate answer to it. There were multiple factors leading to this phenomenon, most notably state-sponsored corruption and deliberate tolerance to malpractices. Pakistan by all means has a soil, which proved to be very suited for the propagation of an underground economy since the very early days of Independence when the allotment mafia came into existence and many notorious elements turned rich overnight. They are still dominating the ruling structures.
The negative effects of the underground economy are plentiful - it creates distortions in statistical data vital for economic planning and macroeconomic decision-making, but its most devastating and direct effect is considerable losses of tax revenues of the state. Theoretically, losses of tax revenue not only refer to a static result, ie the tax revenue lost by the fact that the taxes payable failed to be levied or collected for all kinds of reasons, but also mean a dynamic loss process.
In Pakistan, tax revenue losses due to an inefficient and corrupt tax machinery are equally significant. The tax officials not only do not properly enforce the promulgated laws, are always hesitant to probe tax frauds but also take active part in providing their "expert services" for exchange of money to tax evaders and plunderers of national wealth. They are active and potential generators of untaxed black money in the country.
In Pakistan, the tax revenue losses stemming from the underground economy can be briefly summed up as under:
-- Taxpayers do not register with the tax departments. One reason for this might be the activities they undertake, which are illegal or even criminal, and another reason might be that the taxpayers attempt to escape registration and interlope for the purpose of tax evasion, despite the legal nature of their business;
-- Although a taxpayer registers with the authorities but he resorts to non-reporting with the connivance of corrupt tax officials.
-- Taxpayers indulge in under-reporting so that a wide gap exists between the tax liability reported and the tax which would be payable if the returns were correct.
It is an irrefutable fact that tax revenue losses due to the underground economy, in turn, aggravate income distribution and the wealthy classes became more powerful, thus making the entire society subservient to their interests and control. These colossal revenue losses reduce the efficacy of allocation of social resources thus seriously retarding equitable distribution of societal benefits to cross-sections of society.
It is an incontrovertible fact that the income gap among Pakistanis has been gradually widening and the trend of rich becoming richer and the poor poorer is gaining strength. Generally, the analysts have attributed this to economic policy, but they have neglected the impact on income distribution of tax revenue losses generated by the underground economy. Virtually, all types of hidden incomes arising from vast and widespread underground economic activities escaped tax regulations and this should be considered as an important cause of the widening Pakistanis' income gap over the last 30 years. The introduction of feasible and effective countermeasures requires the removal of causes that generate black money and taxpayers' non-compliance. The theory of economics of taxation tells us that critical factors determining the taxpayer's compliance level include benefit incentives, social pressures and a self-regulating mentality.
The established causes for taxpayers' non-compliance are:
-- Selfish non-compliance, ie the taxpayer makes a cost benefit analysis with regards to tax non-compliance and then decides that this course of action can generate greater net gains for him;
- Non-compliance through ignorance, ie taxpayers do not intend to violate the tax laws, but choose so because of their unawareness of tax obligations; and
-- Social non-compliance, ie taxpayers' behaviour is influenced by the attitude of the whole society towards approving tax avoidance and evasion.
Removing of the selfish non-compliant should be tackled from the economic perspective. It is necessary to reduce taxpayers' economic earning arising from underground economic activities and tax evasion. Even more important step would be to devise measures to enhance the taxpayers' cost of evasion.
The most disturbing aspect of the Pakistani tax system is weak enforcement, whereas the FBR's perspective is that the fault lies with the tax legislation. It is a proven fact that the promulgated laws are not enforced effectively and whenever any shortcoming is pointed out, the FBR stalwarts blame tax legislation. The evidence of this attitude is reflected in the promulgation of the new Income Tax Ordinance in 2001 - a useless venture having nothing new to ensure proper collection of direct taxes. Another example is that of the VAT-mode GST which has not been implemented since 1991 due to the unholy alliance between the tax officials and businessmen.
The mere promulgation of new laws cannot ensure enhancement of tax revenues, the greater need is to end corruption, reform tax structures and improve the attitude of the tax collectors. In Pakistan, one never hears of sending tax evaders to prison for their illegal acts. This confirms extreme slackness on the part of the tax administrators or their connivance with the tax dodgers. Instead, punishment of the tax evaders is restricted to nominal fines or penalties encouraging them to remain in the fold of the underground economy, which is getting larger and larger every day. The unwillingness of the tax collectors to crack down on the players in the underground economy needs proper investigation so that ways are suggested to ensure that in future this unwillingness or collaboration ceases to exist.
The predominant cause of non-compliance in Pakistan remains social non-acceptance of tax obligations. The state has never bothered to promote a tax culture through education of the masses who have never been informed of their duties towards the state, nor are they convinced of proper utilisation of taxes by the government. There exists a relation of bad faith between the taxpayers and the state, which needs to be addressed through a process of reconciliation. A new social contract is needed to convince the citizens that taxes paid by them are to be utilised exclusively for the benefit of the country and not for providing a life of luxury to rulers and the civil/military bureaucracy.
The fundamental solution to promote a tax culture is to popularise knowledge of the law through education, media and information services, enhancing the citizens' awareness of the need for tax payments, raising the status of compliant taxpayers thereby promoting the idea that paying taxes is an honour, whereas evading taxes is a national disgrace. This is indeed a difficult task requiring a long period of time to change people's perception, but to do this work and do it as soon as possible is indispensable if we want to survive as a self-reliant nation. The task of attacking the underground economy and forestalling the losses of tax revenue, the most important and radical channel is the deepening of reforms. The conventional formulae and half-hearted attempts will not work. The State will have to show its muscle to crack down heavily on the underground economy. All tax reforms, which are being initiated vigorously these days by obtaining loan from foreign donors, will become useless unless the black economy and its causes are eliminated once and for all. Our state is presently controlled by corrupt politico-administrative structures where people with huge money power are the key players.
How can the agenda of tax reform succeed in isolation? The need is to purge society, make all financial transactions transparent, eliminate money power and corrupt administrative structures. Only then colossal loss of tax revenue can be restrained. The misplaced emphasis on tax reforms without tackling the issue of the underground economy, will bring more hardship for the common people of Pakistan as in the frenzy of collecting more taxes, the incidence of taxation would be shifted on to the poor and the vulnerable ordinary people and those with invincible money power (the generators and protectors of the underground economy) would remain outside the ambit of tax obligations.
The state has to give up its policies of appeasement towards plunderers of the national wealth and tax evaders. The foundations of corruption and rent-seeking activities of the state functionaries have to be destroyed with full force; otherwise any effort for tax reforms would be nothing but another national waste. The tax-to-GDP ratio can only be improved significantly if the process of economic reforms, especially elimination of the underground economy goes hand in hand with tax reform agenda. Once the State shows a positive attitude by cracking down on the underground economy, the citizens will certainly reciprocate by paying their taxes diligently and honestly. This can be the only way to control and eliminate losses of tax revenue in Pakistan.
(The writers, tax lawyers and partners in HUZAIMA & IKRAM (Tax and Pakistan), are Adjunct Professors at Lahore University of Management Sciences)