Introducing tax measures to make taxation system equitable and efficient

Promoting equity

Equity is one of the golden principles of taxation policy. Many empirical and non-empirical research studies have identified pivotal role of equity in taxation to optimize societal welfare. Equity ensures taxation of real income on progressive basis. It is of two types: horizontal and vertical.

Horizontal equity requires that the taxable persons with equal levels of income must pay the same amount of tax for a tax period in which such income is earned. This aspect of equity develops a perception of fairness among taxable persons, especially small and medium ones, and so encourages them to ensure compliance with tax laws.  

On the other hand, vertical equity requires that the taxable persons with different levels of income must pay different amounts in taxes such that the taxable persons with higher level of income are subject to higher taxes as a percentage of their income than those taxable persons falling within lower income brackets.

Vertical equity has a significant role in reducing income gaps between high-income earners and low-income earners during a specific period. So, based on the concept of equity, a tax becomes proportional if all the taxable persons pay the same percentage of their income in the form of tax—regressive if the taxable persons with higher income level pay tax as a small percentage of their income; and progressive if the taxable persons with higher income pay a greater percentage of their income as tax.

Needless to mention that overwhelming portion of tax revenue in the advanced economies comes from direct taxes, which are effectively enforced. This could be one of the reasoning why developed countries are successful in maintaining the lowest gap between higher income earners and lower income earners. Contrary to this, the developing countries, like Pakistan, are collecting major portion of their tax revenues through indirect taxes and presumptive withholding taxes. It is pertinent to mention that the Chairman FBR has recently made a statement that 90pc FBR income tax collection comes from withholding taxes and only 5pc to 10pc comes from voluntary tax compliance. 

It is considered an uphill task for a state with heavy reliance on indirect taxes to maintain equity and hence to optimize societal welfare. Importance of equity can also be estimated from the fact that governments explore various ways within indirect taxation policy such as targeted exemptions and zero rating on essential items such as food and social necessities for reducing the regressivity of indirect taxes such as sales tax/value added tax.

Given the significance of equity in taxation policy, this is an opportunity for stakeholders to come up with concrete proposals to assist the government in making income tax policy more equitable.  

Removing tax distortions and anomalies

Removing tax distortions and anomalies, and phasing out of tax concessions, as well as giving exemptions are helpful in achieving equity in the taxation system. To promote economic growth and to achieve economic efficiency, it is essential that taxation policy is neutral to economic agents. A neutral taxation policy does not always interfere with the allocation of resources and its application does not modify the decisions of consumers and investors concerning consumption and investment. Moreover, a neutral tax policy leaves production undistorted so much so such a policy is helpful in achieving broader tax base; taxing broader base at lower rates; optimizing tax revenue; enhancing economic productivity; and stabilizing economy.

Phasing out tax concessions and exemptions

Similarly, phasing out of tax concessions and exemptions is imperative not only to prevent loss of tax revenue, but also to broaden the tax base, to make tax system simple and neutral, to increase tax compliance and to reduce risks to businesses. It is worth mentioning that during FY2018-19, the government sacrificed income tax revenue of Rs 141 billion due to tax exemptions and concessions. Tax concessions and exemptions also give rise to a question of transparency in the fiscal policy as major beneficiaries of such concessions and exemptions have rarely been published. They also complicate taxation system, forcing tax authorities to put additional resources to prevent misuse of tax concessions and exemptions.  

Broadening tax base

Narrow tax base in terms of tax return filers remains the main concern for the FBR. Despite massive changes in the tax policy in the recent past, such as differential withholding tax rates for filers and non-filers and active taxable persons and non-active taxable persons, the recently-released data of the FBR has shown 2.34 million tax return filers by January 31, 2020. Although there is 40pc increase in tax return filers over the same period last year, but the number is not capable to be overjoyed keeping in view the potential pool of the taxable persons in the country. To achieve neutrality, efficiency and progressivity, it is imperative that a tax system has a broad base; having all taxable persons in its net.

Facilitating taxpayers

Last but not least, facilitation of the taxable persons and ease of doing business are important policy areas from economic viewpoint. Investors largely assess jurisdictions on these parameters before undertaking investments. Empirically better doing business ranking is found significantly associated with larger foreign direct investment (FDI) inflows. Importantly, Pakistan’s ranking on the ease of doing business index has improved from 136 in 2019 to 108 in 2020. However, to stimulate business activity and to attract more FDI inflows, Pakistan has to further improve its position on ease of doing business index especially by making tax procedures and tax payments easier and business-friendly.

 

The writer serves as Additional Director Intelligence & Investigation (Inland Revenue) at the FBR.