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

Pakistan is an unfortunate country. Common man is deprived of basic education, medicine, housing, employment and physical security. This is the direct consequence of national spending, for these heads, in the last sixty four years being less [as a percentage of resources generated] then all other countries of the world except certain Sub-Saharan African nations.
This persistent and consistent lack of investment in human capital has brought us to the present social, political and economic chaos. Widespread corruption, at all levels, erosion of authority of institutions and degradation of value standards is the natural outcome or result of these intellectually flawed national priorities. The result is natural and tertiary resolutions, like impartiality of higher judiciary cannot bear sustainable fruitful results unless fundamental corrections are made in national priorities.
There is effectively a vicious circle similar to chicken or egg first scenario. We do not have funds therefore we do spend on human capital. As defective human capital is being produced therefore a paradigm to change socio-economic system and a critical mass is not being created that could lead to sustainable pressure against corruption and degradation in values. This circle will go on as usual unless there is a social revolution to break the same.
Minor corrections are no more relevant. There is pathetic low tax-to-GDP ratio [in simple terms being tax collection, especially direct taxes] that leads to huge government borrowing even for non-development expenditure effectively leaving nothing for development expenditure. Resultantly, we are heading towards a big public finance chaos that in its worst form can even lead to local currency default. Economic condition cannot improve in sustainable manner without investment in human capital for which we have no money.
[In the short run, whatever we will additionally collect even from the levy of RGST will effectively be eaten up by interest payments on borrowings]. Present situation is not encouraging. This is the outcome of the political and socio-economic paradigm that prevailed in this country in the last 63 years. There can be lengthy but necessary debate on this topic, however the present article is restricted to the causes of present state of affairs in the taxation system of Pakistan, being a vital part of overall economic system.
In order to identify the solution we need to seriously undertake a broad based analysis, however, this is not the subject of discussion of this article. Nevertheless, few glimpses may appear naturally in the course to follow. This article is focused on the particular subject of consumption tax and attempts to identify the relevant issues that are necessary to be studied for any non-political, impartial and transparent debate on the subject.
IS RGST A RECIPE IN THE PRESENT STATE OF AFFAIRS? Managers of Pakistani economy, including the lenders (IMF and others), firmly, but not wholly correctly, believe that 'one' and the only step to improve the Tax to GDP ratio is implementation of broad-based Consumption Tax in the form of Value Added Tax, now renamed a Reformed General Sales Tax [RGST].
On the other hand, businessmen, various economic analysts and some major political parties, including PML (N) representing commercial centres of Lahore, Faisalabad and Rawalpindi and MQM representing Karachi, Hyderabad and Sukkur believe it to be a wrong or misplaced 'Recipe'. Notwithstanding the arguments on the other side [government] it appears to be a half-hearted attempt only being a compliance of dictation by the lenders. I would refrain to pass any view or judgement at this moment. Any sensible reader would be able to conclude, on his own, if the issues raised are patiently understood and there is a will for long-term resolution.
In my view the biggest tragedy is that common man of Pakistan, who is going to be directly affected, positively or negatively, as the case may be, is ignorant and is not represented in all the economic policy decisions affecting their lives. This can only happen in Pakistan. There is a social disconnect. Even now Pakistan is a non-participative democracy that may be worse than any dictatorship. Even now establishment [bureaucracy] is firing the shot whereas people believe, or at least they are being told, that they are represented. Solution lies in increasing the participation, direct or indirect, rather than looking again towards other solutions including re-emergence of some form of dictatorship.
In my personal capacity I have been directly involved in the implementation of sales tax, since 1990, including present legislation. Furthermore, I have been the member of almost all bodies and task forces formed for the improvement of taxation system [policy and administration] in Pakistan after 1985. In my professional capacity, I have represented clients in implementation, appeals and dispute resolution. This three pronged experience is relevant and the purpose of this article is to try to give an independent view on the subject. I firmly believe that there had been effectively no homework on issues that are relevant to the subject.
We are trying to introduce a law, directly affecting every citizen of this country, poor or rich, agriculturists or city dwellers on borrowed knowledge and experiences. Discussions on this important issue are generally either based on incomplete knowledge with political orientation or a legal review of various provisions. Means to achieve effective and practical implementation or economic implications are rarely thrashed out. Following paragraphs contain a small attempt towards that objective.
CONTENTS OF THE DISCUSSION
This discussion paper includes the following:
(1) History of evolution of consumption tax in Pakistan;
(2) Experiences in post-1996 period after the introduction of VAT;
(3) Zero-rating of export oriented sectors;
(4) Possibility of removing the distortions - preparedness;
(5) RGST, VAT and sales tax - old wine in a new bottle; and
(6) Way forward and solutions.
HISTORY OF EVOLUTION OF CONSUMPTION TAX IN PAKISTAN Originally, sales tax, both on goods and services was a provincial subject. In 1948, sales tax on goods was taken [temporarily] to be a Federal (central government) for 'one' year. Subsequently, that consumption tax on 'goods' constitutionally became a federal subject. Incidence on 'services' was retained as a provincial matter under the 1973 Constitution. Original migration, its continuation and distribution of particular taxes and duties between federation and the provinces is not based on empirical studies or people's mandate. It is effectively a bureaucratic decision.
There are very few countries in the world [being federations under the constitution] where across the board consumption tax, on value added basis is levied on national [federation] basis. It is so as a comprehensive VAT system requires commonality in charge and centralisation of collection, which is not easily attainable in a federation. This unique 'divisive' [where right to levy consumption taxes on goods and services lie with the provinces and federation and vice versa] constitutional right does not exist anywhere in the world except countries like Canada, Australia and New Zealand.
These exceptional kind of federations all represent well documented economies with clear distributive process for collection of revenue on national basis. Can that be modelled in Pakistan? It is yet an untested proposition. Across the board VAT, in practical sense, implies a consumption tax on both goods and services with 'input adjustment', in all situations, horizontally and vertically. Input on goods and services to be available against levy on goods and services and vice versa.
From 1948 to 1996, sales tax on goods was levied as a 'production tax' by the federation. Tax was payable by the manufacturer at the time of removal of goods from the factory, [in India this system still continues]. In almost all the cases value for the purposes of this levy was notional market value; not being the actual consideration.
Consumption tax on services has effectively never been introduced. A Federal Excise Duty was aggressively [technically unconstitutionally] and extensively used to trespass the provinces' sphere, right and ambit of taxation. This trespassing was existent especially in the sectors of telecommunication, insurance, advertising and banking.
In summary, in Pakistan across the border consumption has never been imposed. In the following paragraphs, I will explain the deliberate and non-deliberate distortions introduced in the hybrid form of consumption tax system over the time. The crucial point to discuss is whether or not as a society, with the present tax culture, and fractured documentation structure, would we be able to actually apply and implement an across the board consumption tax.
Is it not a case of introducing a tax without political will with an 'intentional discreet agenda' to provide another excuse for intellectual, political, bureaucratic corruption that would disguise and camouflage the actual reasons of low tax-to-GDP ratio? The real problem lies in direct taxation.
No country can impose an effective and equitable tax system unless there is an inherent minimum documentation in the system and all the stakeholders are on board. RGST may be a very good recipe, however, unless all the stakeholders are on board it can never be effectively implemented. We should learn from the past experiences. An imperfect implementation is more dangerous than no implementation as it dilutes the government's writ of taxation.
There is no legacy of value added based consumption tax in this region. India, though much better organised then us in taxation and documentation system, due to its federal structure is still struggling. Bangladesh has done fairly better in this sphere; however, constitutionally it is a unitary system of government. One of the primary reason of ineffective implementation, especially at retailers and wholesalers level is non-participative and impotent role of provincial and district governments and an apparent lack of trust between provinces and the federation.
EXPERIENCE IN POST 1996 PERIOD AFTER THE INTRODUCTION OF VAT In 1996, one major change was introduced in the consumption tax system in Pakistan. Production-based tax was converted into a tax at the time of sales, with input-output adjustment. This was the beginning of VAT; however, from 1996 through 2010 continuity of the following features resulted in a state where real VAT system could not be enforced.
(A) LEVY OF TAX AT NOTIONAL PRICE BY THE RETAILER For almost all the consumer items, sales tax was recovered at Retail Price at the manufacturing stage. Thus intervening sectors (retailer, distributors and wholesalers) remained outside the net. This system was supported by the legislation in the form of Third Schedule to the Act. In a cursory way, this seems to be a minor distortion only, however, from the practical viewpoint it is a very vital aberration in the system.
Big revenue spinners like cigarettes, beverages, and general consumer items fell under this regime. Under this system government revenues were guaranteed at the production stage. There is a security of a guaranteed collection of revenue for government, which impliedly discourages incentive to implement the law at the secondary stage. Furthermore, as a necessary consequence, since general consumer items were so taxed therefore a tendency developed to remain outside the tax net for other items amongst the retailers and wholesaler community;
(B) EROSION OF WRIT OF GOVERNMENT BY RETAILERS AND WHOLESALERS In addition to this deliberate act, being a measure adopted to achieve revenue without efforts ie the operation of the Third Schedule, there was complete failure in bringing into tax net the retailers, wholesale and distributors for all other products even for non Third Schedule items. It is a daylight reality that all locally manufactured or imported products irrespective of the quantum of turnover for prescribed threshold are 'traded' without sales tax by wholesalers and retailers.
We all know that present threshold for a retailer or wholesaler to be in the tax net is Rs 5 million per annum whereas almost all such almost whole of the market enjoy an 'unconstitutional implicit exemption'. Now this implicit challenge of writ of government is being attempted to be brought back in this fragile environment. This leads to the important socio-economic question about timing of implementation of new taxes or a new regime.
There are various empirical studies on the matter and they all favour the view that best time for such measures is flourishing economy. The other important prerequisite is collaborative political will on national level and consensus to tame the spoilt and pampered child being the trading community not ready for documentation;
(C) NO TAX ON IMPORTED PRODUCTS Imports were effectively placed under 'presumptive VAT'. This is a curse of the highest order. This an implicit acknowledgement for non-documentation, under-invoicing and availability of Afghan transit goods in the country with a recognition that there is no practical measure to document and sale of imported products; and;
(D) NON-SERIOUS AND NON-COLLABORATIVE APPROACH OF FEDERATION AND PROVINCES FOR SERVICES TAXATION There was no serious co-ordinated [Federal, provincial and district level] effort to bring services section into the tax net. Main revenue generators, being telecommunication, banking, insurance etc remained trespassed by Federal Excise Duty. Other service like 'advertising' etc remained in such a mess that one of the major group engaged in that sector obtained a stay against payment on legal plaint from the high court.
(To be continued)