FeaturedNationalVOLUME 19 ISSUE # 4

Challenges and imperatives for economy reforms

The transformation of Pakistan’s economic landscape is a critical endeavor marked by significant steps, such as the removal of the ‘No-questions-asked’ presumptive income tax in the fiscal 2020 budget. While this move was a stride towards economic documentation, the subsequent declaration of prevailing presumptive tax rates as minimum tax revealed a high-handed approach, prompting a significant number of small and medium taxpayers to exit the documented sector.

Moving forward, the key to sustainable improvement lies in the implementation of structural reforms. Until the administration complements its crackdown with these meticulously identified reforms, which are currently languishing in relevant ministries, a lasting positive change seems unlikely.

The restructuring of the Federal Board of Revenue (FBR) has regained prominence. The caretaker finance minister is actively developing a reform plan for the FBR, proposing the separation of policy and enforcement, and the creation of an independent Customs board. These ideas have surfaced intermittently since the days of the Central Board of Revenue (CBR). The privatization ministry recently expressed that any expansion of the government’s size doesn’t inherently qualify as reform. Instead, the focus should be on role separation and transparency enhancement within the existing 20,000-plus FBR workforce.

The urgency of this matter is underscored by the upcoming visit of an International Monetary Fund (IMF) technical team to Pakistan for discussions on tax reforms. The current taxation system in Pakistan hinders economic growth and documentation. The FBR’s role has become overly focused, if not confined, to extracting more from compliant taxpayers, sometimes to the point of harassment.

The tax policy in Pakistan is heavily skewed toward indirect taxes, with most direct taxes collected indirectly. According to Privatization Minister Fawad Hasan Fawad, 93 percent of the tax revenue comes from voluntary or withholding taxes, while only a meager seven percent is directly collected by the FBR. Despite sending numerous notices, the actual recovery remains disproportionately low. This highlights that FBR notices often generate noise without significant merit, providing little benefit to the exchequer.

These statistics support the complaints of SME businesses and individuals who argue that FBR officials frequently issue excessive notices and subsequently engage in under-the-table deals. Regardless of the specifics, the FBR has struggled to expand the tax base, placing the burden of collection on the corporate sector, where tax obligations have surged by 40 percent since 2016. This shift incentivizes entities to remain outside the formal system.

The stagnant growth in the number of tax filers reflects the inadequacy of aggressive government plans to increase it. The continuous escalation of the minimum tax based on turnover regime by the FBR obstructs progress. Initially introduced to encourage tax filing and offset paid taxes, the shift to the minimum tax regime on revenues and the collection of sales tax for mainly informal suppliers are gradually taking place.

The broad income tax withholding schemes, resembling the VAT mode of Sales Tax, have transformed income tax, intended to be a direct tax, into an indirect tax. High rates of minimum tax based on turnover further complicate the tax structure. This convoluted system, where taxpayers are essentially coerced to become tax collectors for the FBR under the threat of penalties, not only burdens the formal sector to the point of stifling it but also encourages evasion of documentation and perpetuates the informal sector.

Eliminating the ‘No-questions-asked’ presumptive income tax in the fiscal 2020 budget was a crucial move for documenting the economy. However, designating the prevailing presumptive tax rates as minimum tax demonstrated a heavy-handed approach, leading many small and medium taxpayers to exit the documented sector by closing existing businesses and reopening under a different name.

In the domestic market, this situation has discouraged growth, while exporters face competitiveness challenges, especially with difficulties in obtaining refunds for small players and new entrants. Some resort to illegal practices like flying invoices. To genuinely implement reform, the government should prioritize direct taxes, in both form and substance.

The government must cease accommodating non-filers by imposing taxes on their transactions and compel filing by numerous businesses and individuals avoiding compliance. Despite having access to various forms of data and technology, the key to successful reform lies in the political will to disrupt powerful circles within the government and those influencing them.

Multilateral and bilateral entities have consistently urged the Pakistani government to reform the power sector, revamp the tax structure heavily reliant on indirect taxes (disproportionately affecting the poor), address escalating poverty levels (currently at 40 percent), and manage current expenditure, which annually diminishes available fiscal space. Additionally, warnings about water scarcity were ignored, resulting in Pakistan’s current status as a water-stressed country.

A recent World Bank official advised the government to consider the broader economic context, cautioning that the creation of a new institution promising substantial investment inflows based on pledges (memoranda of understanding, not legally binding contracts) might not offer a quick fix for the economy. Economic theory suggests that foreign investment gravitates toward countries with a robust economy, projected growth, and strong macroeconomic fundamentals, including ample foreign exchange reserves to meet import bills for industry and households alike.

In conclusion, the imperative for meaningful economic reform in Pakistan extends beyond the elimination of presumptive taxes. The government must prioritize direct taxes, fostering compliance and discouraging illegal practices. Addressing challenges in the domestic market and bolstering competitiveness for exporters necessitate strategic interventions. Multilateral and bilateral recommendations for comprehensive reforms in the power sector, tax structure, and poverty alleviation should not be ignored. A holistic approach, driven by political will, is essential for navigating the complexities and ensuring sustainable economic growth.