Understatement of tax expenditure

ARTICLE: The Public Finance Management Act of 2019 defines tax expenditure as follows:

'The revenue which Government foregoes through the provisions of tax laws that allows deductions, exclusions or exemptions from the tax payer's taxable expenditure, income or investment, deferral of tax liability or preferential tax rates'

The Act states in Section 8 that

'The Federal Government shall, in respect of every financial year, cause to be laid before the National Assembly, Finance Bill consistent with Article 73 of the Constitution including statement of the tax expenditure of the Federal Government'.

Consequently, the Federal Board of Revenue prepared for the first time a Tax Expenditure Report, 2020, for submission to the Parliament along with the Federal Budget of 2020-21. The tax expenditure estimates are for the tax system of 2019-20.

The overall estimate for tax expenditure is Rs 1150 billion, equivalent to 2.8 percent of the GDP. It is Rs 378 billion in income tax, amounting to 0.9 percent of the GDP. The remainder, 1.9 percent of the GDP, is in indirect taxes, viz., sales tax, customs duty and excise duty.

The focus of this article is on tax expenditure in income tax. The tax concessions and allowances in the income tax primarily benefit the richer segments of society. In fact, special provisions in the Income Tax Ordinance are an embodiment of elite capture of the tax system of Pakistan.

The tax expenditure in income tax is classified into allowances, tax credits, exemptions from total income, reduction in tax rates, reduction in tax liability, exemptions from specific provisions and others. Altogether 258 different types of tax expenditure have been identified and quantified.

FBR must be strongly commended for preparing a comprehensive tax expenditure report for the first time. Earlier there used to be a, more or less, cursory presentation of tax expenditure in an Annex to the Pakistan Economic Survey. Last year, income tax expenditure in this Annex was reported as Rs 142 billion, equivalent to only 38 percent of the estimate that has emerged after in-depth examination of the income tax system in 2019-20.

What are the biggest tax expenditures in income tax reported by the FBR? These are the initial depreciation allowance leading to foregone revenue of Rs 30 billion; tax credit for balancing, modernization and replacement of Rs 65 billion; tax credit to non-profit and welfare organizations of over Rs 21 billion; tax exemption on pensions of over Rs 60 billion; exemptions on profits of the SBP of Rs 50 billion and the exemption from corporation income tax to Independent Power Producers (IPPs) implying Rs 27 billion of foregone revenues. These five big tax expenditures add up to Rs 253 billion, equivalent to 70 percent of the total tax expenditure in income tax.

A few simple tests are administered on the above estimates. The initial depreciation allowance in 2019-20 was 25 percent on plant and machinery. Given the corporation income tax rate of 29 percent, the tax expenditure of Rs 30 billion implies that the investment amount on which the allowance was claimed was only Rs 414 billion. Clearly, only a fraction of investment in plant and machinery has availed the tax benefit and the remainder of the benefit carried forward. Does the tax expenditure for 2019-20 include the revenue loss due to the carry forward of this provision from previous years?

The tax expenditure on SBP profits is reported as Rs 50 billion. This is the revenue that would have accrued if the SBP had been treated as a normal corporate entity. However, the entire profits of the SBP accrue to the Federal Government. Therefore, there is no tax expenditure here.

The revenue loss due to the lifetime exemption from CIT to IPPs is reported as Rs 27 billion for 2019-20. This is much smaller than the tax expenditure reported in the PES as far back as 2013-14 of Rs 52 billion. The IPPs are guaranteed a rate of return. How can the tax expenditure come down 48 percent, even if allowance is given for a fall in the standard rate of the corporate income tax since 2013-14?

There is also a problem of lack of inclusion of a number of tax expenditures which are embodied in the income tax law. Perhaps the biggest concession in Pakistan's direct tax system is the bloc wise taxation of personal income as opposed to taxation of total income. This reduces the marginal tax rate and especially benefits the richest tax payers.

For example, there is fixed and final deduction at source of dividend and interest income. A taxpayer whose marginal tax rate is 25 percent pays only 40 percent of the tax that he should pay on interest income that accrues to him. The average marginal tax rate in Pakistan is 14 percent according to the data on tax returns. Therefore, there is significant tax expenditure associated with bloc wise taxation of unearned capital income.

Another example of an exemption which benefits disproportionately higher income persons is the tax treatment of capital gains on shares and properties. According to the existing provisions, transactions which take place after a given holding period are exempt from capital gains taxation. Therefore, the tax expenditure arises because of this holding period limitation. Other countries, like India, have a lower rate of advance capital gains tax of 10 percent on long-term transactions.

FBR has missed out on the quantification of tax expenditure in a number of other areas which could be significant in magnitude. For example, goods exports are subject to a 1 percent tax on exports. The profit margin on export sales could be higher especially since 2017-18 when the rupee has depreciated sharply. Another area is Behbood Certificates which are tax exempt. The amount invested in these certificates is over Rs 800 billion and in 2019-20 the return on these certificates was relatively high. Similarly, a lower rate of the fixed tax on dividends is applied in some cases.

Inclusion of the above tax expenditures could increase the total revenue foregone to over Rs 500 billion, equivalent to 1.2 percent of the GDP. This is close to the estimated ratio in India.

There is need also to recognize that the Act covers all Federal taxes and not only the taxes collected by the FBR. In particular, any tax expenditure in the petroleum levy will also need to be included by the Ministry of Finance.

Overall, the FBR has made a good start in quantification of tax expenditure in the income tax. The methodology initially has been static in nature and no effort has been made to allow for the dynamic implications of a fiscal incentive on the size of the tax bases and the overall impact on tax revenues, both direct and indirect.

Further, a policy paper should be prepared following the finalization of the Tax Expenditure Report on which tax expenditures need to be withdrawn. A subsequent article will look at issues related to tax expenditure in indirect taxes.

(The writer is Professor Emeritus at BNU and former Federal Minister)

Copyright Business Recorder, 2020