FeaturedNationalVOLUME 19 ISSUE # 19

Toward a fair and sustainable tax system

In the realm of taxation, the imperative to combat tax dodging, whether through avoidance or evasion, has become increasingly urgent. To ensure fairness and sustainability in our fiscal policies, it is crucial to overhaul the existing tax framework.

Pakistan is confronted with a staggering annual tax evasion of approximately Rs5.8 trillion, constituting 6.9 percent of the GDP. Within this, evasion related to POL products stands at an estimated Rs996 billion, facilitated by smuggling and other illicit means.

In a presentation delivered to Prime Minister Shehbaz Sharif and the Special Investment Facilitation Council (SIFC), it was highlighted that the annual revenue lost due to tax evasion amounted to around Rs5.8 trillion, based on fiscal year data from 2022-23. The evasion breakdown includes Rs888 billion from the retail sector, Rs562 billion from the transport sector, Rs498 billion from independent power producers (IPPs), Rs355 billion from items prone to smuggling, Rs342 billion from exports, Rs148 billion from real estate, and Rs1.607 trillion categorized under ‘others’. Sales tax evasion emerges as the highest, potentially reaching Rs2.9 trillion annually, while the customs gap is estimated at around Rs0.6 trillion, including under-invoicing and smuggling.

Conversely, the IMF’s Diagnostic Report suggests that the policy-level tax gap might not be significantly higher, possibly peaking at 12.9 percent of the GDP. Federal tax revenues stand at 9.1 percent of GDP, federal non-tax revenue at 1.2 percent, and provincial taxes contribute around 1 percent to the GDP, totaling 11.4 percent of the GDP. On the expenditure side, federal expenditure amounts to 12.9 percent of the GDP, provincial expenditure to approximately 6.1 percent, resulting in a total expenditure of 19 percent of the GDP. This leaves a gap of 7.6 percent of GDP between total revenues and expenditures.

Addressing tax compliance alone could close these leaks, injecting 5.8 percent of the GDP annually into the national coffers. However, this tax evasion, also known as the fiscal gap or fiscal deficit, is typically financed through domestic and external borrowing, pushing the country into a debt trap, as per an independent economist.

Given the dire fiscal circumstances, the government is contemplating restructuring the Federal Board of Revenue (FBR). Pakistan not only suffers from chronically low tax collection relative to GDP but also places a disproportionate burden on middle- and lower-income groups. This is exacerbated by a large undocumented or informal economy beyond the tax radar, and certain lightly taxed sectors such as agriculture, property, retail, and finance. Consequently, there’s a heavy reliance on consumption taxes like the general sales tax (GST) and excise tax across the economy.

In addressing tax dodging, which encompasses both tax avoidance and tax evasion, it is imperative to ensure that all sources of income are taxed. The proliferation of tax loopholes necessitates a crackdown on avoidance before considering higher taxes on the wealthy. Establishing robust institutions is essential for sustaining an effective tax system in the long term. One crucial step towards achieving this is the implementation of a ‘national income tax’ covering all forms of income.

Rather than relying solely on regressive consumption taxes, there should be a swift transition towards taxing all income in a progressively fair manner. This could involve some direct taxes being levied proportionally or flatly to facilitate ease of administration and promote economic documentation, while others are imposed progressively. Exceptions may be made for transfer payments to safeguard vulnerable segments of society.

Taxing interest rates would not only encourage individuals to redirect idle resources from the financial sector to more productive endeavors in the real economy but also foster equitable resource allocation across income groups for funding public goods. This approach would help mitigate income and wealth inequality perpetuated by suboptimal taxation policies influenced by vested interests, often shielded by collusion between these interests and political parties or policymakers.

Therefore, there is a pressing need to adopt a comprehensive tax regime that encompasses all national incomes. Such a system is vital not only for reducing income and wealth disparities but also for addressing the issue of undocumented economic activities, as it covers all sources of income—including those of lower-income groups. The proposed ‘national income tax’ would replace consumption taxes like the sales tax and complement other direct taxes such as wealth tax, income tax, and corporate tax.

In conclusion, the adoption of a national income tax emerges as a pivotal step towards rectifying the flaws inherent in our current tax regime. By targeting all sources of income and promoting progressivity, such a tax system not only addresses income and wealth disparities but also fosters economic transparency and resilience. It is incumbent upon policymakers to heed this call for reform and pave the way towards a fairer and more sustainable future.