Frequent changes in legislation: Tax-to-GDP ratio lowered

SOHAIL SARFRAZ

ISLAMABAD: The frequent changes in tax legislation have distorted the overall tax structure, which has played a key role in lowering tax-to-GDP ratio in Pakistan.

Sources told Business Recorder that a report on the tax gap analysis revealed that frequent changes in tax legislation has made the overall tax structure incoherent and tax base narrow: Tax policy reform in Pakistan has often been piecemeal and disconnected.

Many changes in the tax system were either made to cater to the interest of specific economic sectors or firms, or introduced as matter of administrative convenience, as was the case of zero rating of five sectors.

The government does not know the revenue losses of the incentives given, and has no rigorous system to evaluate the objectives and benefits.

These policies have contributed to the narrowing of the tax base and the decrease in tax effort. They have also compromised the fairness of the tax system, reduced voluntary compliance and increased tax.

Sources said that the main problem with the tax system is its sustained inability to raise adequate revenue to finance the public sector budget. In fact, over the 2000s tax revenue has barely kept pace with GDP, and the tax revenue to GDP ratio even declined in the last years of the decade.

Based on international comparisons, Pakistan is a low taxing country. Given the large development needs for social services and public infrastructure, there remains a structural fiscal gap equivalent to about five percent of GDP.

The efficiency costs of the tax system to the economy are high: Pakistan's tax system levy taxes on different economic sectors and types of assets at very different marginal effective tax rates, which create significant distortions. Although some distortions may be intentional, the real consequence of the distortions is that many investment decisions are guided by tax considerations as opposed to economic considerations.

The result is an overall less efficient allocation of resources and lower levels of output and rates of economic growth for Pakistan. These distortions are caused, among other issues, by the favourable treatment of certain investments and sectors.

The report said that currently, the tax laws are such that individuals with the same income or businesses with the same profits can be treated very unequally in terms of the final taxes the law requires them to pay. This report shows that gap estimates vary widely across sectors. The horizontal unfairness of the tax system is exaggerated by the uneven application of tax enforcement: while compliant taxpayers bear the full burden of taxes, the failure of tax enforcement mechanisms allows other taxpayers to evade their taxes with a large degree of impunity.

Even though the basic structure of Pakistan's tax system is broadly in line with international practice, these taxes have become more complex over the years, because of exemptions, other preferential treatments, and ad hoc changes to the structure of those taxes. The extensive use of withholding taxes, often being considered a final tax - as opposed to being adjustable against final full liabilities - has added to the complexity and arbitrariness of the tax system. The inadequate standards in maintaining tax data do not allow a complete study of the impact of these distortions, sources said.

In spite of partial reforms, there is a long way to go to fully modernize the tax administration. This long-standing bottleneck is characterized by over-reliance on easier "tax handles" through an extensive system of withholding taxes, inefficiencies in administrative structure and operations, and weak enforcement. Around 58 percent of the legal tax base still goes untapped. The situation gives rise to the inadequacy of revenue yields and loss of confidence in the fairness of the system due to large horizontal inequities, sources added.