"The subjects of every state ought to contribute toward the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue, which they respectively enjoy under the protection of the state."
[As Henry Home (Lord Kames) has written, a goal of taxation should be to] "Remedy inequality of riches as much as possible, by relieving the poor and burdening the rich.'" (Adam Smith - AN INQUIRY INTO THE NATURE AND CAUSES OF THE WEALTH OF NATIONS 1776).
Revenues, in addition to finance public funding, meant for distributive justice, which is an important function of tax policy. Economic justice relates largely to distribution of tax burden and benefits of public expenditure. It is a component of the broader concept of social justice, which encompasses, besides distributive justice, such questions as treatment of women and children, racial and religious tolerance in a society. Tax policy is a democratic method to influence the distribution of income and wealth on desired lines.
The main ingredients of this policy can be (a) progressive direct taxation of income, wealth, and property transactions, (b) taxation of commodities (customs duty, excise levy, and sales tax) purchased largely by high-income groups, and (c) subsidies (negative taxation) on goods purchased by low-income groups. In Pakistan we are moving from progressive taxation to regressive taxation. It is a dangerous step that is bound to create ever-widening gulf between the haves and have-nots in a volatile society that is already divided on economic, geographical and ethnic lines.
A successful tax system must reduce inequalities through a policy of redistribution of income and wealth. Higher rates of income taxes, capital transfer taxes and wealth taxes are some means adopted for achieving these ends. In Pakistan, there has been a gradual shift from equitable taxes to highly inequitable taxes. The shift from removing inequalities through taxes to presumptive and easily collectable taxes has destroyed the entire philosophy of taxes. This deviation has transferred the burden of taxes from the rich to the poor.
The primary function of a tax system is to raise revenue for the government for its public expenditure as well as for local authorities and similar public bodies. So the first goal in development strategy as regards taxation policy is to ensure that this function is discharged effectively.
Performance of the Pakistani tax managers is highly disappointing as fiscal deficit remained high during the last decade and though the revenue targets fixed annually were achieved during the last five years, yet the Tax-GDP ratio remained dismally low. In fact, for the last many years tax revenue targets are met through regressive taxation, having negative impact for the poor.
More and more people are being pushed towards poverty line due to inequitable distribution of income and wealth in society. In the absence of genuine industrial growth neither Tax-GDP ratio can be improved nor economic stability and sustainability be ensured. Thus the important issue is not how taxes are collected, but the manner in which they are levied, vis-à-vis their impact on the various segments of society.
In any society, initial developmental efforts are generally marked by inflationary tendencies in an economy. Inflation, if uncontrolled, may thwart all development plans and bring misery to the poor. A reasonable degree of price stability should be a primary concern of a government's economic policies.
The overall level of economic activity in an economy depends upon aggregate demand, relative to capacity output. At times, the level of aggregate demand may be insufficient to secure full employment of labour and other factors of production. At other times, aggregate demand may exceed available output at full employment level. Government intervention in both the cases becomes essential to correct such disequilibria in the economy.
EQUITY PRINCIPLE If a given amount of revenue is needed to finance public services, then each taxpayer should contribute in line with his ability-to-pay taxes. Those who possess more economic power (income and wealth) should contribute more to the public exchequer and vice versa. The duty to pay taxes is seen as a collective responsibility rather than a personal one.
The ability-to-pay principle views tax policy issues in isolation to incidence of public expenditure. Many regard this principle as the most equitable and just method of taxation. It is emphasised primarily for its redistributive role. We in Pakistan have completely deviated from this principle, which is a constitutional obligation of the government. We must follow the Quranic injunctions in this regard, which unambiguously and unequivocally command us to spend in Allah's way whatever is surplus after the fulfilment of one's legitimate needs [2:219]. There is no room of concentration of wealth in a true Islamic society.
It is painful to note that the present structure of presumptive taxation has complicated the poverty problem of Pakistan. According to an Asian Development Bank (ADB) study, the tax system of Pakistan, which was progressive till 1990, was converted into a regressive regime in 1991 with the introduction of certain withholding provisions in the Income Tax Law and VAT-type tax in the Sales Tax Act, 1990.
The result is that during the 20 years' period (1991-2010), tax burden on the poorest households is estimated to have increased by 27.4 percent, while it declined by 15.9 percent on the richest households. Pakistan's indirect tax system is aggressive and biased against the poor putting greater burden on the lower income households than the upper ones, shows a report, "Social Development in Pakistan; Annual Review 2004", issued by the Social Policy and Development Centre (SPDC) in May 2005.
It states that the poorest 10 percent of households contribute 16 percent of their income to the three indirect taxes - General Sales Tax (GST), Central Excise Duty (CED) and Customs Duty. However, the report reveals, the burden of tax progressively declines as income rises and the richest 10 percent of households contribute only about 10 percent of their incomes to the indirect taxes.
The report states that Pakistan's tax regime consists of four main revenue sources; GST, CED, Customs Duty and Income Tax. Its structure is dominated heavily by indirect taxes, which combines over two-thirds (68 percent) of combined federal and provincial tax receipts. If surcharges are included, it observes, the indirect taxes rise to over three-fourth (76 percent). In terms of the share of federal taxes, indirect taxes account for nearly half (46 percent), and if surcharges are included, it touches 55 percent, the report said.
According to the report, the average share of direct taxes for high income countries is 46 percent, while in the low income countries, it is 28 percent. Iran and India post direct tax shares of 40 percent and 29 per cent respectively as compared to 27 percent by Pakistan. The GST claims 9.3 percent of the income of the poorest 10 percent of households, but only 5.9 percent of the income of the richest 10 percent.
In other words, the burden of GST on the lowest deciles is 58 percent higher than the highest deciles. Thus the CED is the most aggressive tax, with the burden on the lowest deciles being 100 percent higher than on the highest deciles. The customs duties are the least regressive with the burden on the lowest deciles being 28 percent higher as compared to that of the highest deciles.
The policy-makers have exempted selected food items like wheat and rice from the GST rate. However, this does not imply zero-rating of GST on account of the fact that the inputs that go into the production of these items are subject to tax. That's why, the nominal tax rate of these items is zero, the effective tax rate amounts to about 7 percent.
The average burden of direct taxes is 0.3 percent, while the burden of indirect taxes is 13 percent. Nevertheless, the structure of personal income taxes is still progressive. The lowest six deciles are exempted from taxation of their incomes, and the burden of income on the 7th, 8th, 9th and 10th deciles is shown to rise progressively.
However, it adds, the average burden of personal income tax on household incomes halved from 0.6 percent in 1987-88 to 0.3 percent in 2001-02 and the progressivism of the tax also declined over the period. This can be discerned from the fact that while the burden of personal income tax as a percentage of household income has doubled from 0.1 to 0.2 percent for the 7th deciles, the corresponding burden for the 10th deciles has declined by half from 4.3 to 2.1 percent.
"The preceding incidence analysis of the tax regime shows that the richest 10 per cent of households bear the least burden of indirect taxation, and that their relative advantage with respect to direct taxes has further improved over the last decade and a half.
The report issued by the SPDC is a warning for the policy-makers. In the report, the impact of presumptive taxes on goods and services under the garb of the income tax law has not been taken into account. Had it be done, the ratio of direct taxes would have shown a further declining trend. The incidence of such taxes, which are imposed under income tax (sic), is borne directly by the consumers and the worst hit are the poor people.
They have to pay GST on supplies of iodized salt, which is sold under brand names. In the sub-continent when the British rulers imposed salt tax, there was mass movement of disobedience which forced them to withdraw the levy. What a tragedy that in post-independence period, we have imposed exorbitant GST of 15% on salt. What makes the situation more painful is the fact that nobody has ever raised voice against this cruel tax. It shows national apathy.
Determination of a tax base capable of measuring an individual's ability-to-pay is a major problem of any tax system. This rule is incorporated in the form of progressive rate schedule for personal income tax, estate duty, and property tax world-wide.
In Pakistan, we have moved from this policy to unequal sacrificial rule where privileged classes are paying meagre personal taxes and the poor people are compelled to pay GST of 15% [it is as low as 2% to 4 % even in Japan and Singapore, which are affluent societies] and ever rising costs of public utilities and POL products.
Being directly violative of Quranic injunctions, the government must immediately take due cognizance and try to remove these dichotomies. Taxes should be meant for the welfare and benefit of public at large and to make the state invincible; not for the luxuries of rulers and state functionaries.
BENEFIT PRINCIPLE According to this principle, an equitable tax system is one under which tax payments are based on the amount of benefits received from government services. In other words, the cost of government services should be apportioned among individuals according to the relative benefits they enjoy. Clearly, implementation of the benefit principle presupposes determination of the incidence of public expenditure before deciding distribution of tax burden. Thus it encompasses issues of both tax and expenditure policies.
Tax policy should be used as a tool of distributive justice. The government should launch programmes, financed mainly through taxes, to solve the twin problems of unemployment and poverty. These welfare-oriented schemes may also include subsidised/free medical and educational facilities, low-cost housing, and drinking water facilities in rural areas, land improvement schemes, and employment guaranteed programmes.
Once people see the tangible benefits of the taxes paid, there will be better response to tax compliance. Taxes cannot be collected through harsh measures and irrational policies. The rulers and tax bureaucrats have to demonstrate by their actions a credible and an exemplary inspirational model for the taxpayers to motivate them to pay taxes honestly and diligently.
Earmarking, a fiscal practice under which revenues from one or more sources are pooled into a separate independent fund to be used to finance certain pre-determined public services, has never been followed in Pakistan for reasons best known to financial managers. The purpose of earmarking is to ensure stable funding for important public activities.
Another objective of earmarking is to introduce market prices into the budgetary process. In this sense, earmarked taxes become an indirect form of market prices charged for public services rendered. Among the conditions for successful earmarking, the following are more important:
-- There should be a clear-cut linkage between the tax levied and the benefit received.
-- Expenditure is well defined so that the taxpayers can identify its obvious benefits.
-- Linkage between earmarked revenue (eg from motor vehicle tax) and predetermined expenditure (eg on construction and maintenance of municipal roads and bridges) is tight.
-- Revenue is in the form of direct user charger/benefit tax (eg a toll).
Traditionally, financing of road expenditure from tolls, motor vehicle taxes, and fuel taxes has been considered an area with a strong economic rationale for earmarking. Similarly, airport tax is generally levied to meet expenditure on airport maintenance.
The principle of earmarking could be applied to such municipal services as water supply, and sewage disposal by linking them to water and sewer charges which, in many cases, are components of the property tax in the sense that the base for these charges is the same as used for property (eg annual rental value). In recent years, a number of countries have utilised taxes for establishing 'employment zones' and this earmarking has produced excellent results.
It is an established fact that despite resorting to all kinds of illogical policies and unjust withholding taxes, the successive governments in Pakistan have failed to improve the tax-GDP ratio (which remains around 10%). The burden of many presumptive taxes levied under the Income Tax Ordinance, 2001 (which are nothing but a form of indirect taxes) has been shifted from income earners to consumers and clients.
These presumptive taxes have distorted the whole tax system, destroyed the economic growth and made the consumer/client the ultimate sufferers. Moreover, these despotic, short-term, myopic and figure-oriented revenue collection measures have even failed to reduce budget deficit not to talk of bringing any meaningful change in the common man's life.
The country has been facing an ever-worsening unemployment crisis and a perpetual challenge of rapid industrial growth. But no government has ever thought of 'earmarking of revenue' for 'employment zones'. Such employment zones can cater for:
-- Creation of employment
-- Technological renovations
-- Export promotions
-- Town renovations; and/or
-- Experimentation with new economic management systems.
In the wake of devastations brought by floods, Pakistan is in dire need of establishing a number of "Employment Zones', which should be low-tax or tax-free for corporate income and for companies creating new jobs. It can be an effective tool to reduce the mounting unemployment burden and to help boost industrial/business growth.
The government should identify areas where structural employment is particularly high and then earmark revenue for establishing employment zones in those areas. Out of total federal collection of taxes for current fiscal year, at least 25% should be transferred directly to an independent fund for establishment of 'employment zones'.
The evaluation of our existing tax system with reference to the foregoing objectives is a difficult task because various other policies (like public expenditure policy) may be geared to achieve the same objectives. The Task Forces (sic) on tax reform, have not concentrated on these questions, but rather confined themselves to superficial aspects of the tax system suggesting just a few procedural changes here and there.
The foreign-sponsored Tax Reform Project, launched by the FBR with US $123 loan/aid, hardly touches the fundamental issues faced by our tax system. To what extent the redistributive objective has been served and what was the relative role of tax policy in it is a difficult question to answer. Moreover, the various objectives of tax policy may not always work harmoniously.
Rather, they are often in conflict with each other if not mutually exclusive. Since the tax system of a country grows out of the interaction between political judgement and economic rationale, the process of compromises and trade offs is influenced by political expediency and economic logic, the former, in most cases, having the upper hand.
In fact, political requirements and economic thinking change with time, giving new directions to tax policy. As Richard Bird has observed, "Tax reform is, therefore, a never-ending process, not something that can be brought about once and for all and then forgotten."
Long-term fiscal policy: Every year we have an avalanche of amendments in the form of a Finance Bill. For the common man, it is impossible to comprehend such frequent changes in the tax statutes. It is a great tragedy that millions of man-hours of tax collectors, taxpayers and tax advisers are squandered away in grappling with the torrential onslaught of such amendments. The government should avoid unnecessary experimentation with tax codes. There should be a five-year fiscal policy without too many changes so that people can arrange their affairs in long term.
Credibility of system: Tax system can be said to be functioning properly only if it:
-- Settles assessments promptly ie within the tax year;
-- Collects the determined taxes in time without causing undue hardship to the taxpayers;
-- Provides for an independent and efficient appellate machinery to look into the grievances of taxpayers; and
-- Quickly disposes cases in appeals and settles claims for refunds. These goals are yet an unrealised dream of tax reforms initiated by CBR. No program of resource mobilisation of tax can succeed unless:
-- A fair and efficient tax system is evolved;
-- The taxpayers change their attitude towards tax obligations through proper compliance;
-- Tax administrators assure that maximum facilitation is extended to taxpayers;
-- Tax evaders are dealt strictly in accordance with law; and
-- Honest taxpayers receive treatment they deserve.
Accountability of tax administrators: No effective mechanism has so far been evolved to effectively check any unfair practices on the part of tax administrators. They are not made liable to punitive actions and/or pecuniary damages even after the final fact-finding authority adjudges their actions arbitrary, excessive and beyond their assigned powers. The Federal Tax Ombudsman should be given the statutory power of awarding damages in such instances.
Restoring the confidence of taxpayers: Taxpayers must be given adequate rights before the State justifies strict actions for enforcing tax obligations. For restoring confidence of taxpayers the State should promulgate Taxpayers' Bill of Rights in the coming budget that must:-
-- Safeguard and strengthen the rights of taxpayers;
-- Ensure equality of treatment;
-- Guarantee privacy and confidentiality of their declaration;
-- Provide right to assistance by State in tax matters;
-- Guarantee unfettered right of appeal through an independent tax appellate system; and;
-- Provide facilities for independent review of disputes with tax authorities.
Objectives of tax reform agenda: There is an immediate need to improve both the system and the human fabric that controls it. The tax system must provide:
-- Rule of law and certainty of tax to be imposed
-- Principles of proportionality, efficiency, effectiveness, flexibility, continuity and equity
-- Tax harmonisation
-- No double taxation or intentional non-taxation
-- Strict anti-tax evasion rules and protection of honest taxpayers against administrative highhandedness
COUNTERING TAX EVASION Ostensibly, money for industrial and business growth and public benefits is scarce, but colossal unaccounted cash supply is circulating in the economy in search of further undercover gains. Our political culture supports racketeering. Tragically, this social evil is doubly compounded as it necessitates greater and greater tax burden on law-abiders. The most crucial problem faced by us is devising of astute and stringent measures to curb tax evasion, thus, distributing the burden of taxes fairly and justly in society-the rich should pay more, but they are enjoying tax exemptions.
The honest taxpayers are disillusioned by the fact that ruling elite is not only not paying its taxes, but also abusing their contribution for unprecedented luxuries. If we want to bring any meaningful change in our tax system, the progressive taxes, abolished since 1977, should be restored and regressive ones to be abolished forthwith. Tax amnesty schemes are to be dispensed with once for all and unexplained assets must be confiscated by the State for the benefit of the poor.
(The writers, tax lawyers and authors of many books, are visiting professors at LUMS) (www.huzaimaikram.com)