Pakistan’s tax regime is perhaps one of the biggest impediments to economic growth. High tax rates and complexity discourage the undocumented economy to enter the tax net whilst stifling capital formation in the documented economy. A simplified approach is needed.
In demanding a 30% income tax, the government is working on an implied assumption that non-taxpayers have 30% of their income left over each year, which, if coaxed, will be paid over to the government in the form of taxes. That is not a sound assumption. Notwithstanding a general instinct to avoid taxes, a high tax regime is the reason for a thriving tax evasion environment in the country. Which leaves the government to use the “stick approach” to widen the tax net.
Recent efforts to tax the undocumented economy have been based on a sector-by-sector approach. This approach has its limitations. Each sector exists in an ecosystem with its suppliers, customers, and service providers. The ecosystem then overlaps with other sectors with their own ecosystems. Implementation of the current tax regime thus becomes a complex exercise of negotiations and management of wider economic interests.
The current regime has left large swathes of the economy undocumented, hence unable to invest in large scale manufacturing. At the same time, businesses in the documented economy are unable to retain sufficient profits to enable future investments (restricting capital formation). The domestic industry as a result does not develop, creating reliance on imports to meet the needs of a large population and resulting in a perpetual current account deficit (CAD). To meet the constant demand for dollars, the government incentivises exporters. But healthy exports in turn fuel domestic demand, which is met by increased imports, resulting in an increased CAD. The cycle of boom-and-bust continues.
Our finance ministers have alluded to tax regimes in western economies to justify current policies. This comparison is unrealistic. Western economies have benefited from a steady supply of cheap raw materials to fuel economic growth for decades – a legacy of their colonial past. More importantly, they are at a different stage of capital formation. Access to capital is much easier given the well-established capital markets and large pools of foreign investment. In these economies taxing savings and investments makes sense. But in Pakistan, the results of such policies are detrimental. All our capital markets are in need for development.
The current scenario has left the county at the mercy of foreign lenders. The task of raising money made more difficult given the global environment. The current state of negotiations is reminiscent of an incident faced by the last Mughal Emperor Bahadur Shah Zafar who was under the watchful eye of the British Resident. Bahadur Shah once gave some jewels from his treasury as a gift to one of his subjects. This prompted a visit by the British Resident who demanded that the gift be returned by its recipient. Bahadur Shah had no choice but to comply and the gift was promptly returned to the treasury.
The challenges of poor tax revenue and low capital formation can be overcome by shifting towards a simplified tax regime – a single tax rate of 10% on income across the board. The maths of this exercise stacks up. If the undocumented economy is the same size as the documented economy (estimates vary), then collecting 10% of total would result in a doubling of the tax revenue.
This policy will have to be implemented for at least two decades. The bureaucracy will need time to adapt to the challenges of taxing a wider population whilst businesses will need time to successfully develop local industry. There is also a matter of building trust. The existing taxpayers will not invest in new ventures unless they have complete confidence in the longevity of the policy. A new taxpayer would want to learn from the experience of early adaptors. So, confidence and trust building will take time.
Success would also require effective management of all stakeholders – Government of Pakistan, foreign lenders, current taxpayers, and the would-be taxpayers.
The Government would need to ensure that it does not find itself losing tax revenue. This could be achieved by putting a 10% tax on all non-taxpayers whilst taxes on current taxpayers can be reduced in a phased manner (see below). Based on the successes of the first year of implementation, incidence of taxes on the existing taxpayers can be reduced over the next three to four years such that everyone is taxed at a flat tax rate of 10% (agriculturalists included).
If the government can demonstrably increase tax revenues and the tax base, the foreign lenders would be amenable to the new regime. Opening doors for further funding. The existing taxpayers will need a clear roadmap towards a simplified tax regime (albeit progressively) and reduction of bureaucratic burden (immediately). For instance, income tax can be reduced by 5 percentage points per year (to bring it down to 10% over time) along with steps to reduce complexity and bureaucratic burden. Incentivising the current taxpayers would ensure that they focus on the next phase of industrialisation which is needed to achieve import substitution.
The undocumented economy‘s contribution to tax revenue is not significant (withholding taxes paid) but it does provide income and employment to a significant portion of the economy. Ensuring its prosperity is therefore important. The would-be taxpayers must have absolute confidence that income tax of 10% is the only tax they will have to pay for the next 20 years. Various tools can be utilised to assess whether disclosed income is reasonably accurate, but restraint would need to be exercised to ensure that people entering the tax net are not entering a quagmire of queries and questions.
Several ingredients for successful implementation are already in place. NADRA has the database, and the government has gathered a lot of data on individuals over the last many years. Building upon this strong foundation can achieve the desired results relatively quickly.
Once implemented with a transparent roadmap, the policy will set the ground for increased documentation and industrialisation – attracting foreign and domestic investment to achieve import substitution. This would be a starting point to give direction to the economy. Much more will be needed to bring prosperity. The list will be endless, but some new thought leadership is required to save the country from bankruptcy and set it on a path to sustainable growth.
Copyright Business Recorder, 2022
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