Towards a fairer tax system

The World Bank, in its latest report, ‘Pakistan Development Update’, issues a stark warning: in the current fiscal year, the country’s fiscal deficit is projected to skyrocket to a staggering 8.0 per cent of GDP.

This is a critical situation. To put it into perspective, our tax-to-GDP ratio (income) has been around 10-11 per cent of GDP from FY2019 to FY2023 – meaning we spend almost double what we earn. This excessive spending, which is not on human development but primarily on debt servicing, has severely impacted public service delivery. As a result, over 20 million people live without clean water, almost one in every three people lacks decent toilets, 40 per cent of its population faces poverty, and the same percentage of children under the age of five have stunted growth.

The inability to expand revenue is partly due to Pakistan's ineffective tax system, which has struggled to move beyond taxing imports and consumption, ballooning the share of indirect taxes in total tax revenue. On the other hand, certain loopholes on the expense side need to be plugged in to create a cushion for spending on human development.

This context sets the stage for the World Bank and IMF's consistent advocacy for robust tax policy reforms in Pakistan, especially as the nation prepares for its 25th engagement with the Fund.

The IMF recently published a report titled ‘Pakistan Tax Policy Diagnostic and Reform Options’. The report provides a detailed analysis of Pakistan's tax policy, highlighting its complexities, inefficiencies, and underperformance. The severity of the situation is emphasized by comparing Pakistan's tax-to-GDP ratio of 10 per cent with the average of 18.3 per cent for Upper Middle-Income Countries and 17 per cent for Lower Middle-Income Countries in 2020.

Why it is so?

Let us start with income tax. Pakistan's income tax structure is marked by its complexity, with multiple tax rates and exemptions. The current system, characterized by varying tax rates for different categories of taxpayers, results in a convoluted tax regime. For instance, non-salaried individuals face a higher tax burden than their salaried counterparts, with the highest marginal tax rate of 35 per cent kicking in at an annual income of Rs4 million for the former, compared to Rs6 million for the latter. Such a taxation approach fosters avenues for tax avoidance and evasion.

The sales tax system split between the federal government and provinces suffers from significant administrative complexity. The federal government's jurisdiction over goods, juxtaposed with provincial authority over services, creates a fragmented system that complicates tax collection and enforcement. The proliferation of exemptions, zero-rating, and specific rates further aggravates the issue, undermining the sales tax system's efficiency and potential revenue generation.

Excise duties, particularly on tobacco and petroleum products, represent a significant revenue source. The IMF report indicates that substantial increases in excise rates on tobacco in 2023 led to an estimated 20-25 per cent decline in cigarette consumption. However, sales tax evasion is another challenge in Pakistan’s revenue collection efforts.

To improve the system, the IMF recommends simplifying the income tax structure. The report advocates eliminating the dichotomy between salaried and non-salaried individuals, proposing a streamlined rate structure with no more than four slabs. This simplification, according to the IMF, could significantly reduce compliance burdens and level the playing field across different income sources.

Tax expenditures (provisions in tax laws that allow for special exclusions, exemptions, deductions, credits, or preferential tax rates), a long-standing feature of the Pakistani tax landscape, are earmarked for overhaul. The IMF report underscores the necessity to eliminate all tax expenditures except those mandated by legal obligations, potentially raising about 2.0 per cent of GDP from tax policy measures by FY2026.

Sales tax, another significant revenue source, also needs to be simplified. The IMF report suggests a judicious pruning of exemptions and zero-rating, barring exports, and advocates for a uniform registration threshold across the federal government and provinces. Such measures could not only streamline the tax base but also improve administrative efficiency and revenue collection.

In the realm of excise duties, the IMF report recommends a harmonized approach, particularly for tobacco products. Besides broadening the base to encompass emerging sectors such as e-cigarettes and luxury goods, it has also suggested increasing the excise duty on petroleum products. The IMF advocates that these adjustments will not only enhance revenue but could align Pakistan's excise tax policy with global best practices.

A pivotal institutional reform proposed is the establishment of a Tax Policy Unit within the Ministry of Finance. This strategic move aims to fortify tax policy analysis and decision-making, ensuring a cohesive and informed approach to tax legislation and enforcement.

Looking beyond the immediate horizon, the IMF report lays down a blueprint for structural reforms aimed at bolstering Pakistan's tax capacity in the long term. Central to this vision is the enhancement of tax policy coordination between the federal government and provinces, a step that could mitigate the current fragmentation and foster a more unified tax system.

The proposal for a modern and semi-autonomous tax authority is forwarded as a game-changer, poised to streamline tax collection and enforcement across federal and provincial levels. Furthermore, the transition towards a modern Value-Added Tax (VAT) system and a more equitable property tax regime is advocated.

There is little reason to differ from the IMF’s recommendations. Even without an IMF programme, most of these long-delayed reforms are necessary to tap Pakistan’s revenue-generation potential.

The recommended reforms, including rationalizing tax expenditures and introducing a simplified tax regime, aim to increase revenue generation, which is crucial for reducing fiscal deficit and providing cushion to the government for funding public services and infrastructure projects in Pakistan. By addressing issues like the taxation of retailers, wholesalers, and digital services, these reforms could encourage formalizing informal economic activities, contributing to more transparent and accountable economic growth.

However, one needs to remember that efforts to achieve macroeconomic stability often disproportionately affect lower and lower-middle-income earners.

Increased tax rates, reduced exemptions, and reduced personal income tax slabs might disproportionately affect middle-income earners, further exacerbating income inequality and potentially leading to social unrest.

Likewise, given the significant size of Pakistan's informal sector, broad tax reforms might push more people and businesses into informality to avoid taxes or complex compliance requirements. The government should be mindful that implementing comprehensive tax reforms will lead to short-term economic disruptions, affecting business operations, consumer spending, and overall economic stability.

On the other hand, while the establishment of a Tax Policy Unit and other administrative reforms are a must to improve efficiency, significant challenges could arise in terms of capacity building, inter-agency coordination, and resistance to change within existing institutions.

Going forward, the government needs to ensure the tax structure remains progressive, where higher-income earners contribute a larger percentage of their income. This can be achieved by maintaining graduated tax rates while reducing the personal-income-tax slabs and offering tax credits or deductions specifically designed for lower-income groups. Likewise, it should ensure that the thresholds for income and sales taxes exempt basic consumption items and lower-income earners from tax burdens, ensuring that the tax system does not disproportionately affect those with limited financial means.

Tailored and targeted support measures, phased implementation, and continuous monitoring could help mitigate negative outcomes while ensuring the reforms achieve their intended goals.

It is pertinent to mention here that increased revenue is often considered an end goal in the discussion of tax reforms. This is not the case; the government should clearly communicate and explain how enhanced revenues will be used to improve public services and invest in sectors that have the potential for high job creation, such as infrastructure, renewable energy, agriculture, education, and vocational training programmes.

There is very little room for deviation from its commitment to the IMF if a borrowing country wants to smoothly complete its programme. However, while negotiating for the next loan, the government should propose that during each staff-level review, the IMF assesses the impact of its proposed tax policy reforms on different income groups and adjust policies as needed to avoid unintended consequences, especially on vulnerable populations.

The writer heads the Sustainable Development

Policy Institute. He tweets/posts @abidsuleri