Reformed General Sales Tax: State of economy: need for composite tax package - II

All these factors revealed that by default, even after 1996 amendments, sales tax remained under a hybrid system where consumption tax was, in principle being collected at a single stage of manufacturing or import. Other intervening sectors being retailer and wholesaler continued to enjoy 'unconstitutional' immunity.
This resulted in an implicit encouragement for business of 'trade' as against manufacturing for the reason that there was effectively no direct tax on income from trading. In laymen's terms there is effectively no 'direct tax' on such businesses. For such people Pakistan is a heaven though they may not admit it. In this situation, it is totally unnecessary to complain that there are huge unaccounted assets and non-documented wealth in the country. We allow it legally and deliberately. Can there be any country where virtually for the last 30 years [post presumptive tax regime] there is no 'direct taxation'?
Do we realise the gravity of this error? The ghost of presumptive taxes will haunt our system for a long time unless we exorcise the same with full force. We do not want to do that even now. With this new vigour and enthusiasm [only within the Board Room of Federal Board of Revenue and Block 'Q" of Secretariat in Islamabad] for RGST, the important practical question is the change in psyche and socio-political structure.
This is effectively a fight against a well grown monster with strong financial muscles. Though being a hardcore optimist in such matters, even to the extent of an illusionary, I feel that it is a difficult but an essential task. Our Economic Managers either do not have full knowledge of the ground realities or they are compelled by a misunderstood notion presented by lenders. We want across-the-board consumption tax, however, an unprepared exercise will lead to more negative consequences than maintaining the status quo. Even positive revenue impact will not arise. In the following paragraphs I list down the impediments which have lead to the present ineffective implementation of the current law. The first exercise should be to create the enabling environment so that excuses do not lead to effective impotency of legislation, as is being done at the moment. What I have repeatedly questioned are the changes at the grass root level that would enable an effective implementation. Escape routes for tax evaders can only be stopped when not only the doors but also all the attached windows are closed.
ZERO-RATING OF EXPORT ORIENTED SECTOR In 2005 the biggest distortion in the consumption tax was introduced. I should admit that I was a part of the decision-making process. Under this regime five export-oriented industries being textiles, carpets, leather, sports and surgical equipments were zero-rated instead of zero-rating for actual exports. These sectors contributing a substantial part of total manufacturing GDP of the country were taken out of the tax regime.
Accordingly, tax-to-GDP ratio was naturally bound to be disturbed. Whether this action was correct or not will be decided by the history, however, it is important to accept that this action led to the introduction of the biggest aberration in the system. At the outset, it has to be accepted that there was no technical basis for such policy and we should accept that we had adopted an extreme negative action leading to complete failure in implementing tax system specially managing refunds on exports which is a natural corollary for consumption tax.
It is reiterated that this distortion was created as the refund system had totally failed. During this period business of fake and flying invoices flourished. As a result of that, total refunds issued for actual imports in these sectors exceeded the total amount of tax collected from that sector. It is important to note that total taxes collected included local sales out of such sectors also. The quantum of misappropriation can be judged from the fact that whole taxes collection from local consumption out of these sectors [which would be around 20 percent at least] was swollen up by non-genuine refunds. There is no doubt that correct answer to clear up this menace or mess was effective implementation rather than zero-rating the sector, however, as stated earlier, due to incorrect commercial expediency and pressure from the vested interest, an intellectual crime was committed.
Economic consequence of this aberration is exemplified by a case that in Pakistan almost everything is taxable, but carpet being a luxury item is zero-rated, being a part of export oriented sector. This is only an example. This position is true for almost all such products.
Furthermore these sectors represent a substantial part of total manufacturing sector of the country. Keeping that segment out of tax regime implicitly meant that across the board implementation is not desired or possible. If is it so, then the corrective relationship between tax-to-GDP will never emerge.
From practical viewpoint of the genuine stakeholders of the system, this intellectual crime was undertaken due to the following reasons:
(I) MUSHROOM GROWTH OF COMMERCIAL EXPORT SECTOR Genuine exporters were at a disadvantageous position on account of delay in the issue of refund; whereas mushroom non-genuine commercial exporters in connivance with the corrupt government officers flourished, changing the real dimension of industry; In short, instead of the government, corrupt officers became a silent partner in businesses.
(II) BROKEN SUPPLY CHAIN In reality, a substantial portion of manufacturing and processing for industries is undertaken at small and medium scale units. As that segment is not required to be documented, therefore 'VAT Chain' is broken and exporters are not able to re-claim the whole amount of taxes incurred at different processing stages. This either leads to bringing in of intervening fake records or loss for genuine exporters on account of higher costs if tax is levied at each stage where the chain is broken.
(III) OVER-RELIANCE ON AUTOMATION Release of refunds, unless properly documented, carry a risk of abuse for the government. Automation is not the answer to all the irritants and problems. It is only a tool. Automation can only be effective when whole chain is documented and there is possibility of 'cross matching'. Cross matching looks very easy in theory, however we all know that refunds in Income tax regime were stopped [which led to the introduction of the curse of presumptive tax regime], as refunds of taxes in Karachi were being made for taxes non-genuinely deemed to have been deducted at far off places, not being verifiable like, Khuzdar or Mastung etc. Proper system can only work where there is a nationally integrated data base and there are very strong controls at all places where inputs are placed in the system. This, in my view does not exist, even now.
(IV) NON-GENUINE CLAIM AGAINST LOCAL SALE OF EXPORT-ORIENTED SECTOR Fourthly, it should be considered that around 20 percent of such sectors are local sales which are taxable. Genuine input related to that segment (legally not claimable) may be claimed as refunds arising on exports. No automation or system can check or stop the same. The only real check against the same is effective 'audit', which we all accept has failed.
(V) AVAILABILITY OF SMUGGLED AFGHAN TRANSIT TRADE PRODUCTS Lastly, the factor that is being totally ignored is the availability of smuggled and Afghan transit trade product in the market, for the similar sector [especially textiles]. All the local markets of textiles are flooded with smuggled products or the products imported by abusing Afghan Transit Trade. It is practically not possible for the businessman in that sector to operate under two systems and at the same time it is not possible for the administrator to manage that kind of trade practices. The other stream has to be dried up before implementation of a new regime. You can find 'fake' or non-documented products in the alleys of Oxford Street, however, the shop within the street cannot afford the same. In our country the situation is reverse. If it is so, then can we copy and admire UK VAT system?
POSSIBILITY OF REMOVING THE DISTORTIONS - PREPAREDNESS An important question that is being dragged into unnecessary political and economic debate is the possibility of removing the distortions. This is nothing but an implementation issue. Position will remain the same whether or not we bring the new law, or retain the old one or we call it VAT, RGST or any other name. My initial reaction for the same, based on grass root study is that in the present structure this wish list is not attainable unless major 'irritants', described in the following paragraphs are removed.
For the sake of clarity these irritants are again placed for record:
(a) Recovery of tax at manufacturing stage on ultimate retail price on major FMCG items. This has effectively placed retailers and wholesaler [being a vital link in the VAT implementation] out of the tax net. These sectors contribute over 20 percent of GDP and are flourishing at the cost of all other stakeholders. Other than having no direct taxation, this creates disequilibria in price control (due to non-documentation) when allegations and realities for hoarding and price manipulation arise, as is happening now-a-days in the case of sugar prices.
(b) Imports remained under presumptive indirect tax regime. This effectively means that trail for documentation remained officially not required under the law. In practical terms, it means that sales tax is charged at import stage like custom duty, with immunity from all direct taxes for all subsequent stages of business. For that purpose at present an amount equal to 2 percent of the import value is deemed to be the ultimate price. Relevance and significance of this distortion can be gauged by looking at the quantum of imports as a part of GDP of Pakistan and the trade in that sector.
(c) Zero-rating for export sector as against zero-rating for actual exports.
(d) Special procedures for various sectors such as petroleum, CNG etc, where, in all cases an attempt has been made to exclude traders or dealers from the net of taxation and even if there is any incidence, it is in the form of indirect taxation at single stage.
CHICKEN OR EGG FIRST? All these facts end up in one conclusion that as 'policy' we have deliberately abolished all kinds of 'direct taxation' from Pakistan taxation system for the entire trade, import and service sector. Do we realise the effects and consequences of this biggest intellectual mistake? Now consumption tax, named as VAT, RGST or whatever we call it, is being considered to be a remedy to bring back some 'sense' in the system. This approach again leads to a chicken or egg scenario. The vital question is whether direct taxation policy mistakes are to be corrected first that would eventually force such businesses to concede to documentation to dilute the resistance against indirect taxation, or indirect taxation system is to be imposed in complete sense which will lead to increase in direct taxation collection. It appears that government is adopting the latter approach. At this stage, there is no point to give judgement on the method to be selected; however, it appears that proper homework is required to study the irritants which have choked the system. The possibility of effective removal of distortions can only arise if the irritants which are natural and mostly created by us, are removed. This aspect has been discussed as under:
(I) ISSUE OF MINIMUM THRESHOLD At present, the threshold for being subject to tax is Rs 5 million (turnover per annum) which is proposed to be increased to Rs 7.5 million. We all know that a lot of businesses in the country are undertaken by entities having declared turnover less than this amount. This creates a natural blockade in the system whereby two price mechanisms appear in the market. Nobody would like to buy from a retailer charging 15 percent as against a next door neighbour not subject to tax. To equate the same FBR personnel in very low tones sometimes talk about a 'further tax' of 3 percent [which I disagree totally] for sale to non-registered person. Notwithstanding the technical side this is a practical problem that needs to be solved before any other action. We are discussing all philosophies and economic theories without first resolving this primary market mechanism.
Karachi Income Tax Bar Association has come up with the solution that all intervening sectors be brought into the tax net and 'retailers' be treated as consumer. In their view, this will complete the chain in a certain sense. I do not totally agree with this solution, as the same may create problems for purchases of products by the manufacturing sector and others.
The ultimate solution lies in the internationally acceptable principle that threshold be lowered and all retailers brought into the tax net. For that matter, comparative study is made of the countries where VAT is being practically applied. Thus, removal of this distortion is directly related to implementation and the present suggestion [threshold of Rs 7.5 million] will increase the intensity of the irritant rather than removing the same.
(III) COMPLETING THE SUPPLY CHAIN At discussed earlier, a major 'value addition' for the products for exports, is undertaken by the sectors outside the tax net being small and medium sized enterprises. There is no change in the character of such industries and processes over the time (from 2005 to 2010). Any change in the system [abolition of zero-rating] would either result in creation of non-genuine inputs or effective financial loss to export sector. This is an economic issue and needs resolution even if it is assumed that refunds are correctly and speedily issued.
(IV) REFUND MANAGEMENT There is no tested system of refund. It is agreed that processes have been automated in the most meaningful manner. However, what is not being considered is that delay in refunds and abuse of discretion arises on account of the fact that nation wide data and cross matching with the present framework and apparatus is not possible. This would either require human intervention or delay in the issue of refunds.
(V) INUNDATION OF UNDER-INVOICED, SMUGGLED AND AFGHAN TRANSIT TRADE PRODUCTS Markets continue to be inundated by under-invoiced, smuggled and Afghan transit trade products. In this situation it is virtually impossible to implement consumption tax at the retail or wholesale trade. What we are saying is that the same shop selling "Bata" or "Servis" shoes will charge sales tax on such products, whereas no tax would be charged on under-invoiced imported, smuggled or Afghan Transit Trade product by the same entity. Even if, as an agent of angels, traders agree to charge sales tax on regulated products what would stop them to recover same sales tax on other products and increase price for the consumers in the name of sales tax. In other words, the charge for the consumers would increase without any increase in the revenue for the government. This would be a case of double jeopardy.
PRESENT SYSTEM, VAT AND RGST - OLD WINE IN A NEW BOTTLE It is our duty to let the nation know that there is no difference between the present system, VAT and RGST. In short, it is the reinstatement of the Sales Tax Act, 1990 after removing the distortions. The question is then why it is being said that a new tax is being levied. This is a political mistake of the government that it has not been able to present the case properly to the nation. It is being presumed that all 'exemptions' contained in the present law would be withdrawn. This is not a correct assertion. There are certain items which are not presently taxed, which would be brought into tax net in future, however, exact position can only be ascertained on a comparative study of present Sixth Schedule to the act with the First Schedule to the new act.
There are many items with regard to which there can be an economic debate that the exemption should continue. On the other hand there may be various items which are presently exempt which would be better off if the same are zero-rated, so that input tax is recouped; for example 'medicine'. The biggest folly the government has made in this regard is that a totally wrong perception has been allowed to prevail. It is strongly suggested that a critical review of the present First Schedule [relating to exemption] be made with a clear policy that all food items, education, and health related subjects be zero-rated. Furthermore there should be exemption for items affecting the consumer basket of a common man. The unfortunate part of present position is lack of homework and non-participative role of economist, leaving taxation to be a subject of either politics or law.
The other residuary issue is, whether or not there is a need for a new legislation to incorporate the intended changes. In strict technical sense there is no such requirement and all the objectives can be achieved by appropriately amending the present law. I am one of the people, proposing a new law for the primary reason that there should be a proper debate in assemblies on economic issues. Notwithstanding, through the delay, deferment, or abduction of the RGST a very reasonable objective has been achieved. Debate on the subject of RGST, has raised many subjects which were considered as 'taboo' in the past. Now assemblies, media and general public are talking about 'tax' and 'equitable distribution of wealth'. Notwithstanding the delay, this process will not stop now and there will be betterment provided the debate is carried through positively.
The way forward and solution In a nation's life, deferment of a proposal for the cause of bringing about consensus is a good omen. There is no sacrosanct date for the implementation of RGST. It would be damaging to bring a new law, without preparation and consensus, just to obtain a 'tranche' from the lenders. Even if it is done for this reason, the ultimate result will be negative even for the lender, as it is bound to fail.
I am sure that if RGST is introduced in this manner then within one or two months, following changes will be inevitable:
(i) reintroduction of Third Schedule for FMCG items; and
(ii) Relaxation for the export sectors, especially for release of refunds.
If it is so, then again we will repeat the past mistakes. The solution lies in a Composite tax package. An outline of the same is given as under:
(i) Amendments in the Protection of Economic Reform Act [PERA] to stop whitening of money, including circularization of money for funding under-invoiced imports.
(ii) Abolition of Section 111(4) of the Income Tax Ordinance, 2001 and all other sections, that prohibit enquiry about sources of money.
(iii) Amendments in Provincial Agricultural Income Tax [Sindh and Punjab] to the effect that rate of tax and basis of levy shall be similar to that as laid down in the Income Tax Ordinance, 2001.
(iv) Abolition of right of maintaining 'dual nationality' for Pakistanis and restriction on maintaining foreign currency accounts by Pakistanis in Pakistan over a small limit.
(v) Reintroduction of Wealth Tax with a low rate [not for collection of revenue but for asset documentation) with proper valuation tables including foreign assets but excluding business assets.
(vi) All credits in the bank statements above a certain amount to be reportable to State Bank of Pakistan as to the source.
(vii) Review of the Afghan Transit Trade Agreement.
(viii) Introduction of Provincial Capital Gain Tax with the rate equal to Federal Income Tax Ordinance, 2001. Revision of valuation tables.
(ix) Introduction of Pre-Emptive Right of acquisition by the provincial governments for under-priced properties.
(x) Gradual process of elimination of presumptive taxes from all sectors.
(xi) Reducing the corporate rate of taxation to 25 percent with exemption to dividend income, to promote corporatisation and documentation.
All these changes are to be introduced from March 31, 2011. After the implementation of the aforesaid action, then from June 30, 2011, the proposed RGST should be introduced with following fundamental changes; (i) Decreasing the threshold to Rs 2.5 million;
(ii) Decrease the rate of tax to 7.5 percent; and
(iii) Zero-rating all items of consumer basket of a person having income less than Rs 15,000.
Furthermore, after the introduction of the law an 'Implementation Commission' be made consisting of representatives of all major political parties and other stakeholders. Implementation is to be undertaken and monitored through a participative process instead of non-effective regulations.
There is a way forward for our nation. We carry a heritage of civilisation that is over 2500-year old, where 1947 is a small milestone. Temporary deviations in our thought process which emerged after some wrong decisions in the past should not be taken as a cultural shortcoming. We are a nation of young people carrying a great past and potential for a great future. We only need to adjust our priorities.(Concluded)