Tax reforms

The key to solving Pakistan’s dilemma

Taxation is an extremely important source of funding for any state to finance the running of the governmental functions. Even the oil rich Arab states are now beginning to recognise the importance of this and starting to shift towards a lasting economy with citizens contributing to the national treasury with their share of the taxes.

To put it simply, in all global economies there is taxation, both direct and indirect (in different combinations). Direct taxation is a tax directly levied on an individual or business’s income while indirect taxation entails taxes on products and services whereby consumers are made to pay taxes when they consume these.

In developed countries, realising that taxation is necessary for providing them with necessary facilities, most citizens contribute their share to the state finances. Direct taxation is the dominant part of the tax system in such countries as it accrues some substantial benefits for the economy, people and the state. Importantly, direct taxation allows richer segments of the society to be taxed more and poorer classes are provided with relief and benefits. This proportionate taxation not only helps smoothen the flow of money across various classes of the society but it also helps in ensuring that every citizen has a minimum living standard by providing state assistance where required.

However, a different story is at work in Pakistan. A culture of tax avoidance has long engulfed the business horizons. An ongoing cat and mouse fight between the tax authorities and the taxpayers, with the later believing that it would be a waste to pay off their tax bills due to the deep pockets of the corrupt government officials, has led to a greater focus on indirect taxation. While the tax and state officials rightly point out that no state can perform the necessary duties with the empty coffers, the tax payers also have their point in that they don’t see any real delivery of essential services but instead are greeted with stories of herculean corruption rife all around. The plague of corruption is widely believed to be consuming most of the available resources. Hence, there seems to be a massive break-down of trust between the taxpayers and the “tax-man”.

This serious trust deficit leads to a difficult situation where finance ministry overemphasises on indirect taxation to try to bolster its coffers. Unfortunately this approach has serious negative ramifications for Pakistan’s economy and people which has manifested in worsening the already declining economic situation of the country.

In Pakistan, ordinary people are taxed indirectly on just about everything. Nowhere in the developed world is indirect taxation utilised as heavily as in Pakistan due to the negative effects that it creates for the economy. In Pakistan’s case (and that of many other developing countries following this strategy) the negative impacts far outweigh the contributions raised in this manner due to the missed opportunity costs.

For example, 25-30% had been routinely charged as an indirect tax on every litre of fuel (mainly petrol, diesel, etc) in Pakistan which is a basic necessity for everyday life compared to only 13% in the USA. This way of collecting taxes indirectly leads to inflationary pressures in the economy as the increased transportation costs translates into increased prices for just about everything including the commonly used commodities. The effects are hyper-inflationary in nature because there is a multiplicative rather than an additive element in the inflation passed-on at every level.

Furthermore the pay-rises are not proportionate to inflation thereby forcing people to rely on expensive credit to make their ends meet. Similarly businesses also require more finance to run their operations. This hyper-inflationary environment then leads to higher interest rate which negatively affects the businesses. With higher finance costs many business projects which would otherwise be viable becomes non-feasible. The resulting lack of employment opportunities combined with the limited money-supply puts recessionary pressures on the market. The above issues lead to the devaluation of the currency which in turn results in increased foreign debt burden. As a result, financing costs of the foreign debts rise leading to a higher proportion of GDP spent on debt financing. All this combined with hyper-inflation drags the already estranged economy further back in Pakistan’s case.

The above is a summary of the mess created by the taxation policies pursued by the previous government which are unfortunately continued by the incumbent finance ministry. The result is that while the standard of living of urban Pakistanis is generally considered well-off compared to most developing countries, Pakistan is considered to be lagging behind economically in the league of the nations.

What is actually required is to restore the faith of the taxpayers by implementing a multi-dimensional tax reforms agenda where:

• Taxpayers are encouraged and incentivised for paying taxes.
• Taxpayers are facilitated by making the process easier and fairer, focusing on maximum automation in order to stem out corruption.
• Instead of increasing the tax rates the tax net is constantly widened.
• More focus is given to direct taxation.
• Meaningful tax rebates and reliefs are introduced for the less able sections of the society.
• A system of proportionate taxation is adopted with more affluent contributing more to the treasury.
• Certain exempt sectors are brought into the tax-net (subsidies can be given for assisting any under-pressure areas/products).
• Tax rebates and incentives are introduced to encourage foreign/local investments in key sectors with tax-breaks for transfer of technology etc, as may be required in a particular sector.
• Tax money is actually spent on public welfare and infrastructure projects, which will improve the spending capacity and the business environment in Pakistan.
• The massive corruption in public contracts/projects, now routinely in the range of 40-50% of tender values, is eradicated for better and efficient use of public money through revamping the pay and accountability structures.

With all the natural resources at our disposal, a high proportion of population been young and hardworking and cheap labour availability, a fairer system of taxation culminating into a fairer economic policy can provide the necessary environment to harness the economic potential of Pakistan.

The key reforms outlined above, if properly implemented, can resolve the current enigma facing the treasury. Should such reforms be made with reliance on local resources and a will for change, there is no reason why Pakistan cannot stand on its own feet and become an economic, hub not only for the region but the whole world.

Omer Zaheer Meer is an Economist who is also a qualified chartered accountant, financial analyst and anti-money laundering expert. He can be reached on Twitter @OmerZaheerMeer, or on mail at: [email protected].