Mind the tax gap

The size of the tax gap in Pakistan is almost equal to the amount the country borrowed last year. The tax gap is the difference between the amount of tax collected if everyone paid what they owe, and the amount actually collected.

Regular studies and tax gap analysis help a country strategise its tax efforts and calibrate the focus of tax policies so that all pay their due share and nobody ends up paying extra.

As per last year’s estimates of the FBR, the tax gap of two leading tax streams – sales tax and income tax – is 65 percent and 57 percent respectively. Given the historic fiscal and economic imbalances faced by the country, in the wake of Covid-19 the need to curtail the gap has become earnest more than ever.

Huge structures of black economy thrive behind these figures. Tax experts claim that a large majority of retailers, wholesalers and manufacturing units remain out of the tax net by not registering themselves, or avoid paying their due share. Last year’s government bid to impose a CNIC condition on a certain threshold of transactions hit right at the root of the problem. However, it has yet to come of age. It is surprising to know that one cannot buy a Lahore-Islamabad bus ticket without showing one’s CNIC but it is a big hurdle for traders to record the CNIC number of buyers.

The black economy and the tax gap do not exist in a vacuum. In common parlance, corrupt tax officials are the primary reason for the double-digit tax gap. Well, corruption is everywhere but it takes two to tango. It is an over-simplistic explanation and widely accepted because it generalizes the problem and satisfies our blame instinct. If we look at the tax gap picture from an adequate distance, we get a clearer perspective of the predicament.

Global research suggests that lack of tax culture, weak and underdeveloped tax administration, and low public trust of government institutions are the major drivers of the tax gap anywhere.

Like other places, in our country too, these factors are inter-linked and at times complement each other. During the late thirties, when Joseph P Schumpeter used the term ‘tax culture’ for the first time in his lectures and write-ups, he meant the design and structure of the tax system in a country. The idea has substantially evolved since then. Now it also accounts for tax literacy, complexity of the tax code, an economy’s self reliance, certainty of tax provisions, tax compliance and the tax writ of the state.

In Pakistan, the law administering income tax is comparatively simpler than that of other countries of similar size, population and development level. Similarly, the law administering the sales tax is also fairly drafted except for SROs and frequent changes therein. The problem is the general literacy level, which is abysmally low and aggravates the problem of tax literacy.

Similarly, owing to overwhelming reliance on external financing, tax policies have to adjust to the requirements of donor agencies. This creates compliance gaps in several instances. Uncertainty relating to tax provisions also impacts the tax culture. The tendency of uncertainty avoidance is higher among many of the operators in the black economy. This is why the last two amnesty schemes unequivocally guaranteed straight protection for persons availing the schemes.

Likewise, the weak tax writ of the state also hampers the underpinnings and growth of the tax culture. It comes from weak and underdeveloped tax administrations. Tax officials who have worked for a couple of decades in the department also confess that the tax administration has deteriorated over the last two decades in an unprecedented manner. Frequent experimentation with the system and low investment in the department have been the reasons behind this.

Today, the heavily mandated federal tax administration looks visibly pale before newly established revenue authorities in provinces. It is difficult to dodge provincial authorities. Employees in provincial authorities are well paid and are dispensing their responsibilities in a better work environment. Managed by federal tax men, provincial revenue authorities represent a better model for replication at the federal level.

Low public trust in government institutions also widens the tax gap. There is a plethora of research that establishes the fact that if citizens trust a government or its institutions, they are likely to be more compliant with tax laws. As per a Gallup survey, around 60 percent Pakistanis believed that the government is heading in the wrong direction. Similarly, 63 percent of people expressed mistrust in the judiciary.

To conclude, the tax gap is huge. No single government can fix it in one term. It requires continuous and focused effort. Strengthening the tax administration through authority, autonomy and fiscal independence and appropriate framework for accountability – these are the actions recommended by various tax reform committees and panels constituted so far. However, first things first. So, mind the tax gap first.

The writer is public policy scholar from Lee Kuan Yew School of Public Policy, Singapore and can be reached at akbar@u.nus.edu