While every successive Pakistani government keeps moaning about the low tax to GDP ratio, the taxpayers on the other hand keep reminding their leaders on the need for serious reform in our tax system in order to seek meaningful progress in tax collection. It is only natural and to be expected that people go to great lengths to avoid paying tax. One popular trick in the Middle Ages was to become a monk; these days, shell companies in the Caribbean are a more common retreat in the West and in an environment like ours a simple avoidance to become a part of the documented sector is considered to be the best option! Point being, that it is really up to governments to create an environment and culture that induces people to pay their fair share of taxes. The value added tax, for instance, allows firms to deduct tax paid on inputs from their sales-tax bill, in effect encouraging them to police their suppliers. Then there are the sticks: audits and penalties. Pakistan’s government’s undue emphasis has been on indirect taxation instead of endeavoring to broaden the tax base by: bringing the untaxed into the tax net, removing anomalies, rationalizing taxability and tax rates, and placing prudent checks on corruption within the tax system.

The General Sales Tax (GST) is the main vehicle of indirect taxation being used at home. The share of sales tax in our overall tax collection was recorded at 44% in FY14, overriding the share of direct taxation, which stood at 39% in FY14. Currently charged at 17%, the rate is too high when compared with both neighbors and competitors; only Turkey has a higher rate at 18%. However, in Turkey there exists a reduced rate of VAT (Value Added Tax) of 8% and 1% on essential items including foodstuffs, textile products etc. In fact these very specific cum targeted measures have been mainly instrumental in Turkey’s attainment of a tax to GDP ratio of 20.38%, which is almost double that of Pakistan’s at 10.93%. It is interesting to note that Taiwan and Thailand charge only 5% and 7% sales tax and have tax to GDP of 12% and 16% respectively. Also, Malaysia that charges sales tax at 10% has tax to GDP ratio of 16.10%, and this despite applying a reduced sales tax rate of 5% on essential food items. Clearly Pakistan should also dwell on the taxation models of these comparable nations in order to improve its tax collection.

High indirect taxation comes at many costs that can be damaging to the long-term social outlook of a country. For example, indirect taxation invariably has high inflationary impact, reduces the disposable income of the common man and negates the very concept of tax-rationalization. In addition, it reduces focus from tax-avoidance and tax-evasion in an economy. Therefore, a better approach for increasing tax revenues in our case lies in concentrating on reforms that are not only broad based but also far reaching in nature. Reforms that side by side also: reduce corruption; enhance operational efficiency in the tax collecting machinery by minimizing person to person contact through development of a robust IT (information technology) system; and adhere to progressive direct taxation, meaning higher tax on the higher income brackets in a way that ensures equitable incidence of tax burden without discouraging investment & progress.

All this is not going to be easy and the government will require a multi-pronged strategy in this regard by undertaking holistic tax reforms that shift the focus from indirect to direct taxation in the economy. A significant cut in the GST rate (proposed at about 5%) would give the much needed breathing space to businesses to deliver and divert their resources into more productive and growth oriented activities. Such a shift would also lead to a reduction in tax burden on ordinary people and reduce the average tax per person. While further (external factors are already helping to reduce inflation substantially) reducing pressure on inflation on one hand, this step will increase disposable income on the other. And this in-turn will generate more economic activity thus contributing to higher tax collection provided of course, as mentioned earlier, if we also simultaneously move to revamp our tax collection mechanism along with reforms’ implementation. Further, taxation incentives should be given to trade and industry to encourage them to get into the tax net in order to broaden the tax base and they should in addition be encouraged (through tax breaks) to graduate towards value-added production and services. Finally, the government will be required to ramp up its efforts to curb cross border smuggling, particularly under the guise of Afghan Transit Trade (ATT) as it literally takes away billions of rupees in sales tax from the national coffer, while at the same time rendering the national industry uncompetitive on many counts. Estimates from the Federation of Pakistan Chambers of Commerce & Industry put this value to be around $10 billion per annum.

Still, simply undertaking reforms or revamping the tax collection system may not be enough. Promising new research in behavioral economics can give governments another tool for boosting tax payment: the psychological nudge. Economists have long understood that psychology matters in tax systems. Studies repeatedly find that tax gaps are much smaller than one would predict given the rarity of audits and the benefits of underpayment. Many taxpayers are motivated by more than just pecuniary concerns. Feelings of patriotism and civic duty ease the pain of paying tax (or dodging them; less attractive). Guilt, or the perceived moral cost of violating social norms, also seems to enter the equation. It stands to reason that governments that exploit such emotions would save bundles of money in enforcement. A recent working paper from ‘America’s National Bureau of Economics Research’, documents experiments conducted by economists from Imperial College in London and University of Chicago with the British government, and explains how a government chooses to spend the tax it collects, plays heavily on the emotions of the taxpayers. The less return the taxpayers feel they are getting for their money, the more likely they are to avoid paying. Also, if taxpayers discover that the government’s priorities are more out of step with their preferences than they had previously believed, collections may fall. Interestingly, the work paper also highlights that this phenomenon is typically visible in countries where donations/charity/philanthropy out perform governmental tax collection and it is here that Pakistan immediately comes to mind!