Factors that accelerate Informal Economy

In Pakistan, the tax gap is estimated to be over 11 percent of GDP – a fact that signifies the huge potential for tax revenue. The tax authorities need to exploit this potential in order to mobilize additional tax revenue of more than Rs 3.3 trillion that will jack the tax-to-GDP ratio up from the current 11.5 percent to 23.3 percent. The huge tax gap – almost equal to tax collection of Rs 3.33 trillion – signifies that the size of informal economy in Pakistan is as large as that of the formal economy. Largely, the causes of informal economy are rooted in the tax system. Size and structure of tax burden, efficiency of tax administration in collecting taxes, penalty policy, complexity or fairness of the tax system and compliance costs determine the size of the informal economy.

Higher tax burden

There is no denying the fact that higher tax burden increases the size of informal economy. It is because increasing the tax burden makes it more cost-effective to operate in the informal sector. In Pakistan, the tax base is extremely narrow with 1.26 million tax return filers for the tax year 2017. Tax burden of the assigned tax targets has always been on existing taxpayers. Nonetheless, in view of the narrow tax base and low voluntary tax compliance in the country, many forms of withholding tax are being used to collect taxes from informal sectors; though provisions relating to presumptive tax regime are regressive in nature. The sales tax rate of 17 percent is considered significantly high; many supplies are, however, subject to reduced and even zero rates. Moreover, exemptions are available to many low-income societal groups. Major portion of the tax collection comes through indirect taxes. It means a significant tax burden is on consumption sector which directly affects the low-income groups.

Weak enforcement measures

The tax gap of 11 percent of GDP further signifies taxman’s limited capacity to detect tax evasion. First, the tax administrators do not have human resource enough in number to catch each and every tax-evader. Second, capacity and skill level of the tax administrators is also too limited to detect tax evasion. Third, the tax authorities do not always get assistance from other law-enforcement agencies in nabbing the tax-evaders. Fourth, there are no adequate financial and logistic resources placed at the disposal of the tax authorities so as to facilitate them in carrying out the cumbersome work of conducting investigations against the tax fraudsters. Fifth, tax audits are not being conducted so effectively that they create deterrence against tax-evasion. As tax-evaders fear little of being caught for tax recovery along with penalties and additional taxes, they continue to operate in the informal sector. Sixth, the tax authorities have the capacity to select and conduct audit، thereupon، of only tax affairs of the return filers. Persons not registered for tax purposes continue operating in the informal sector.

Inadequate tax audits

Businesses and individuals do not always cooperate with the tax authorities during audits of their tax affairs. Audits are largely concluded either ex parte or they are based on third-party information, such as from banks. In a number of disputed cases, huge tax liability is assessed on the basis of third-party information such as bank statements or income tax returns. The assessment orders are declared void and of no legal effect by the courts if they are not based on specific provisions of the tax statutes. An immediate reasoning for the poor quality of assessment work is the pressure of reporting every month the number of assessments and quantum of the tax demand created, which is used as one of the criteria for assessing performance of the tax authorities. Knowing the lacunae in tax audit policy and weaknesses of the tax authorities in the conduct of audits, taxable persons foresee little probability for detection of tax evasion. Furthermore, decisions of the appellate authorities in favour of the taxable persons regarding sales tax liability during the period when the taxable persons were liable to be registered also encourage them to operate in the informal economy.

Penalties for tax evasion

In view of the limited tax capacity and deficiencies in the tax statutes, the authorities are not always able to impose and recover penalties and additional taxes for non-payment or late payments of due taxes. For example, although the tax law prescribes penalty for non-filers of tax returns but the appellate authorities vacate the orders of the tax authorities in case no tax is paid or payable with the returns. Non-recovery of penalty for non-filing of tax returns encourages the taxable persons to continue to operate in an informal sector.

Tax & criminal system

Tax criminal system has not yet established in Pakistan. The Directorate General of Intelligence & Investigation (IR) has been established by the Federal Board of Revenue (FBR) to initiate prosecution proceedings against tax fraudsters but owing to lack of resources and excessive litigation issues, the Directorate General of Intelligence & Investigation (IR) has not been so effective in nabbing and, subsequently, initiating prosecution against the tax fraudsters at the desired level. Weaknesses in the tax criminal system encourage informal business transactions.

Complexity of the tax system

A complex tax system riddled with frequent changes discourages taxable persons to register for the purpose of tax and thus encourages taxable persons to operate in an informal sector. For example, under the Sales Tax Act, 1990, persons registered as manufacturers, importers, exporters and wholesalers doing business in textile (including jute), carpets, leather, sports and surgical goods sectors were given benefit to import and supply of goods at a reduced rate of 6 percent, 4 percent or 0 percent under the statutory regulatory order (SRO) 1058(I)/2011 dated 23 November 2011. This SRO was superseded on 1 January 2012 and sales tax rates of 5 percent or 0 percent were introduced on import and supply of such goods under SRO 1125(I)/2011 dated 31 December 2011. Again, this was amended 8-9 times. Through SRO 154(I)/2013 dated 28 February 2013, the zero-rating scheme was withdrawn and replaced with sales tax rate of 2 percent. On 26 July 2013, the rates were further amended to 7 percent, 5 percent and 2 percent under SRO 682(I)/2013. Under SRO 898(I)/2013 dated 4 October 2013, import and supply of fabric was charged to sales tax at the rate of 3 percent and value addition at the rate of 2 percent on commercial imports of fabrics. Such schemes not only provide opportunities for tax fraud but also encourage businesses to keep their actual transactions out of the tax net.

Fairness of the tax system

The tax system in Pakistan offers exemptions, reduced tax rates, zero rating, special schemes, etc., to selected individuals and sectors of economy. Under the prevailing tax system, some individuals and sectors of economy have to share higher tax burden as compared with others. Such a lopsided tax system promotes informal economy.

Tax compliance costs

In Pakistan, tax compliance costs are significantly higher as compared with regional countries. Higher tax-compliance costs discourage taxable persons to register under the tax statues and to make compliance of tax payments and other tax obligations. To encourage formal economy, the tax authorities require to reduce tax compliance costs and to facilitate businesses in filing tax returns, tax payments and fulfilment of other tax obligations.