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Dealing with informality through taxation

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Dealing with informality through

Taxation

Informality is considered a cause of low productivity and poverty in developing economies. It is empirically found that development is associated with declining informality.
It is difficult to find a single unanimous definition of informality due to conceptual differences. Normally, evaders, avoiders and outsiders in respect of state laws and regulations are considered operating in the informal economy. Evaders are covered by the law but they do not comply with laws and regulations; avoiders adjust to remain outside the remit of the laws and regulations; and outsiders are not covered by the laws and regulations. In the context of taxation, avoiders are taxable persons who adjust sales/turnover to keep themselves below the tax threshold to avoid taxes and compliance costs; evaders are those taxable persons who are legally liable but pay no tax at all; and evaders are taxable persons who under-declare sales/turnover and/or inflate expenses to reduce taxable income to evade taxes.
Taxation policy has been widely used as an instrument to reduce informality, considered crucial to allow economy to operate at full employment level, fizzle out underemployment, wipe out poverty, ensure gender equality and stabilize economic growth. Empirical evidence shows that workers in the informal economy face higher risk of poverty than those in the formal economy. The working conditions in the informal economy are inadequate and unsafe, and workers have high illiteracy levels, low skill levels and inadequate training opportunities. Therefore, the informal economies have higher levels of unemployment and underemployment.
In view of multifaceted nature of informal economy, it is not an easy task to reduce its size rather it requires vertical integration and coherence across the range of policies to curb informality. Pakistan is lower-middle-income country typically having a large informal sector, very high self-employment rates and low levels of tax collection. Informal economy in the country is estimated to be as large as size of the formal economy.
The business firms, especially small and medium ones, continued operating in informal economy largely to avoid taxes by keeping costs and revenues off the books. Such a trend restricts growth of these firms in order to keep tax authorities away from enforcement measures. Therefore, there is an urgency to enhance the size of formal economy to correct distortions induced by informality by facilitating the firms to get registration under the tax laws. This can be achieved by lowering the cost of registration and making it easier for the firms to pay taxes and file declarations. In order to bring big retailers into formal economy, Sales Tax Act, 1990, has been amended to integrate Tier-1 retailers across the country so that the tax authorities should obtain real-time data of their sales. Furthermore, the Federal Board of Revenue (FBR) had issued Sales Tax General Order No.2 of 2022 by which a system-based approach has been adopted to integrate non-Integrated Tier-1 retailers with effect from August 01, 2021. If the identified Tier-1 retailers fail to integrate by September 15, 2021, they would be denied credit for input tax equal to 60% claimed in the Sales Tax return for the month of August 2021.
From the past many years, it is considered that property sector in the country is a major destination of all types of black money. Under- declaring or mis-declaring the value of property in order to avoid taxes has become the norm in the country. In certain cases, the declared value of property transaction is as low as 20pc of fair market price. Such a practice has weakened the efforts of documenting the economy. The housing society developers have accumulated enormous wealth by adopting these tactics and avoiding due tax. The money in the property sector is considered as idle and counterproductive for economic growth. It is being suggested to induce money out of property and channelize it towards productive economic sectors that would spur economic growth and result in reduction of unemployment and underemployment.
Necessary changes are being made in Section 68 of the Income Tax Ordinance, 2001. The tax authorities would not use Collector/DC rate as a base to determine property value for assessment of tax rather fair market price of property would be determined by the professional valuers approved by the State Bank of Pakistan to be used as tax base. This initiative to document the fair market value of property transactions is a move in the right direction and requires a must implementation to broaden the tax base. This would not only generate additional tax revenue for balancing the budget but would also document the economy by discouraging lending black money in the real estate.
Further, the government has empowered the commissioner to issue notices under section 114 of the Income Tax Ordinance, 2001, to a taxpayer who has not filed tax return for the past ten years. Earlier, the time limitation for issuance of notice under the said section was five years. With extended tax period, there is ample opportunity for tax authorities to catch non-filers and to recover evaded amount of tax.
In the previous financial year, the government attempted to document the money by imposing withholding tax on bank transactions exceeding Rs50, 000 per day to bring the non-taxpayers and non-filers in the tax net. It is because a considerable number of persons engaged in trading activity are out of tax system. By bringing these persons in the tax net, the number of tax return-filers can be increased significantly.
Earlier, the government introduced tax amnesty scheme to bring business capital in the tax net. It was expected that the amnesty would bring thousands of non-filers in the tax net and would yield revenue to the tone of billions but the results fell short of expectations.
Efforts are also being made to enhance the size of formal economy by denying the input tax benefits to unregistered persons under the sales tax regime. Section 2 (25) of the Sales Tax Act, 1990, reads that ‘a registered person means a person who is registered or is liable to be registered under this Act provided that a person liable to be registered but not registered under this Act shall not be entitled to any benefit available to a registered person under any of the provisions of this Act or the rules made there under’. Thus, not only the registered person but also the one who is liable to be registered under the Act falls within the purview of ‘registered person’. The ‘proviso’ provided in the very definition of ‘registered person’ is an illustration of the intention of the legislature to enhance the size of formal economy as one of the means adopted by the legislature to achieve the aim of bringing as many persons as possible into the formal economy and to provide incentives to persons who are registered under the Act, while expressly disallowing the same to those who fail to do so.

The author is serving as Additional Commissioner Inland Revenue at Federal Board of Revenue, Pakistan. He can be contacted at bilal.hassan@fbr.gov.pk

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