TAXATION POLICY TO DEAL WITH INFORMAL ECONOMY

An empirical research study has estimated that the size of Pakistan’s informal economy is 35.6% of the country’s GDP. Another study reported the size of the informal economy as high as 56% of GDP. According to the World Bank, Pakistan’s informal economy is one-third of its GDP. As per a research study conducted by IPSOS, a leading market research company, the size of the informal/shadow economy in the country is 40% of the national GDP.
The existing tax gap also indicates to what extent an economy is informal. For example, Pakistan’s tax gap – tax not collected due to inadequate tax policy is called policy gap and non-compliance due to weak enforcement is called compliance gap – is estimated to be Rs3.8 trillion, which is almost half of the current year’s tax revenue target assigned to the Federal Board of Revenue. This tax gap is attributable to a policy gap of Rs1.7 trillion and a compliance gap of Rs2.1 trillion.
It is interesting to know the extent of informality within different sectors of our national economy. The larger the tax gap, the bigger this sector and the harder to tax. Annual volume of tax evasion in five sectors, including tea (Rs35 billion), tobacco (Rs80 billion), tyres and automobile lubricants (Rs90 billion), pharmaceuticals (Rs45 billion) and real estate (Rs60 billion) is Rs310 billion, as estimated by an IPSOS research study.
Needless to mention that informal sector employs more children and women. According to International Labour Organization (ILO), wholesale and retail, community and personal services, manufacturing, and transportation are among the primary sectors of employment in the informal economy of Pakistan. Small and medium enterprises (SMEs) have the largest share in the country’s informal economy.
Why do businesses prefer to operate in the informal economy when a substantial incidence of financial fraud exists in the informal sectors? For example, many fraudulent transactions of property transfer have been reported in the real estate sector. Primarily, SMEs operate businesses with small capital. With less revenue and profits, the SMEs could not afford the cost of compliance of operating in the formal sector. For example, costs incurred on registration, tax return-filing, record preparation and maintenance, etc. is beyond the reach of many small businesses, which constitute a major chunk of the informal economy. There are no formal rules prescribing fee structure for the performance of different functions involved in the formal economy so that businesses could estimate the cost of compliance to operate in the formal sector and to prevent them from the high fee charged by agents.
An informal economy is not desirable from a government perspective because less-than-potential tax collection from enterprises operating in the informal economy could cause large fiscal deficits, if financed through money creation; as it would result in high inflation as per the fiscal dominance hypothesis. Further, if financed through borrowing, it would exert pressure on the economy in terms of extra payments of massive debt-servicing charges. Furthermore, reduced tax collection due to a large informal sector is hampering the growth and development of the country. Inadequate revenue also causes an under-supply of public services such as health, education, security, justice, etc. Apart from this, there is an enhanced threat of money laundering and terrorism financing in the informal economy.
Therefore, reducing the size of the informal economy is essential for the government to improve its performance. A number of measures can be adopted to bring businesses operating in the informal sector into the formal economy. Currently, a large number of potential taxpayers are not filing tax returns and wealth statements despite being subjected to withholding taxes on commercial transactions. Fewer than three million taxpayers are filing tax returns and reporting their revenues, expenses, assets and liabilities despite stringent efforts by the tax authorities to maximize the number of tax return-filers. The tax policy of higher withholding tax rates for persons who are not filing tax returns and are not on active taxpayers’ list is being pursued for almost a decade, and it has proved to be fruitful in bringing many potential taxpayers into the formal economy, forcing them to file tax returns to avoid higher withholding tax rates on commercial transactions and to claim tax refunds of excess tax withheld at source.
Another tax policy to bring the maximum number of potential taxpayers within the formal economy is that if a major economic transaction, which is subjected to withholding tax under the relevant provisions of the Income Tax Ordinance, 2001, is undertaken by potential taxpayers, the information should be utilized to make an assessment of income of the non-filer taxpayers and tax should be imposed thereupon.
To enforce tax compliance in a bid to enhance the size of the formal economy, statutory notices are issued with an aim to force potential taxpayers to file tax returns. Non-compliance with such statutory notices attracts penalty proceedings. In case of tax fraud, prosecution proceedings are initiated against the defaulters who do economic transactions without registration and avoid paying due tax.
In the last couple of years, a new tax policy has been introduced that will help trace the commercial transactions of potential taxpayers. The tier-I retailers are required to integrate their point of sales with the central computerized system of the Federal Board of Revenue. Non-integration of the point(s) of sales attracts heavy penalties and also prosecution proceedings. This tax policy is not only helpful in preventing sales tax evasion but is also assisting the tax authorities in booking new taxpayers.
The policy of implementation of a track-and-trace system for specified goods, including tobacco, cement, sugar and fertilizer imported into or manufactured in Pakistan is an attempt to check the under- and non-reporting of revenues so as to reduce informality of these sectors.
Apart from the above, the Federal Board of Revenue uses a large repository of transactional data, asset data and foreign transactions data to identify potential taxpayers who are booked for the purpose of income tax and subsequently are required to file tax returns. Moreover, the entire supply chain from import to retail is being integrated with the FBR system to ensure documentation.

The writer studied Taxation Policy & Management at Keio University, Japan, and is serving as Additional Commissioner (Inland Revenue) Corporate Tax Office, Lahore