TAX REFORMS

Tax Reforms Assignment School of Management, FC College Lahore Due Date: 03-01-2012

Subject of the Assignment: Suggest reforms to the Taxation System of Pakistan

Submitted By Rabbia Nasir Amin (12-10656)

Submitted To Sir Abrar Jameel

TAX REFORMS Contents

1. 2. 3. ABSTRACT .............................................................................................................................................. 2 PRINCIPLES OF A GOOD TAXATION SYSTEM ......................................................................................... 3 THE SHORTCOMINGS IN THE SYSYTEM THE REFORMS ........................................................................ 3 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 PROVISIONS SHOULD BE THERE FOR THE TAXATION OF AGRICULTURAL INCOME ..................... 3 Control on the Indirect Taxation ................................................................................................... 4 TAX RATES SHOULD BE SOMEWHAT FLAT .................................................................................... 5 FEDERAL EXCISE SHOULD BE KEPT IN CHECK ................................................................................ 5 COLLECTION PROCESS AND COLLECTION COSTS SHOULD BE WELL IN PLACE ............................. 6 TAX PLANNING AND TAX EVASION TYPE OF THINGS MUST BE SERIOUSLY TAKEN CARE OF ....... 7 ISLAMIC PRINCIPLES SHOULD BE CONSIDERED ............................................................................ 7 RIGHTS AND DUTIES SHOULD BE SPECIFIED IN LAW .................................................................... 8 APPEALS SYSTEM SHOULD BE MORE EFFICIENT. .......................................................................... 8

REFERENCES .................................................................................................................................................. 8

1. ABSTRACT
The purpose of this paper was to recommend reforms on the taxation system of Pakistan. Since we are yet in our academic phase without any practical experience regarding Taxation, this paper involved a lot of work. Until now, we are on the Income Tax Ordinance 2001 in our course, but to consider the overall system, we could not limit ourselves just to the Income Tax Ordinance. Initially it was hard judging what sources to rely on for this assignment. But then as the semester progressed, sources started getting clearer. For this paper, I studied the prominent legislative documents including Income Tax Ordinance 2001, Sales Tax Act 1990, Federal Excise Act 2005, Custom Act 1969, F.T.O. Ordinance 2000, Wealth Tax Act 1963, and ITAT Rules. It was hard to go through it all, but I tried to at least read the summaries and the prominent sections of each of them. Furthermore just sitting reading them all and having a practical experience are two very different things. So I tried to access people with experience in this section. For this, I had two main sources. My first source was a CA student who is currently doing Articles at Ferguson and has some experience in Tax as well. My second source was my father who is an employee of the FBR. To develop a critical opinion, I also looked at various articles and other information online. These articles etc. did not necessarily pertain to the Taxation of Pakistan. My main focus of this online research was what makes a strong taxation system, its differences with the Taxation System of Pakistan, the online critique on the Taxation system of Pakistan, sources from which the Tax Law of Pakistan is derived, the impact of a good Taxation system on economy, the black practices regarding Taxation and

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commonly used Tax Terminology. However the lack of experience and knowledge are the limitations of this paper. Nonetheless I have tried to make the maximum effort I can. Overall it was a very good learning experience.

2. PRINCIPLES OF A GOOD TAXATION SYSTEM

I felt it necessary to look at the principles of a sound taxation system, because without looking at what makes a good taxation system, we cannot assess whether the taxation system under practice is an effective one or not. As I progress further into the paper and into my analysis, I will turn back to these basic principles for analyzing the scenario in our country. I wont mention much in this regard, as it will be irrelevant. The most relevant stuff I was able to found out is summarized as under. 2.1 Through the Taxation system, the government should be able to raise enough money for spending in national ventures without over-taxing or under-taxing the people. The tax rates and tax slabs designed over here should be enough to cover the Government expenditure but they should be reasonable enough to keep the economic activity going and to prevent people from manipulating their statements. The second very important thing is to keep in view the taxpayers ability to pay. The tax paid by the individuals should be a clear reflection of their ability to pay. I would not go into the detail of this principle here, rather I will turn back to it as I progress for comparing various practices to this Equity Principle Another principle/assumption that underlies the process of taxation is the fact that the taxpayer is paying taxes, because he expects to receive certain benefits on the money he is paying. I wont discuss this point much because thats more related to the economic and capital policies of the state, rather than the design of the Taxation system itself. The system should have transparency and certainty. Any educated and sensible taxpayer should be able to understand how the system works. There should be a certain level of transparency.

2.2

2.3

2.4

3. THE SHORTCOMINGS IN THE SYSYTEM THE REFORMS

Now I will move on to the shortcomings that I found in our system and will give my recommendations on the reforms as well. Although there might be many other reforms that I might have ignored; yet I have made my best effort in picking out the following. There are many shortcomings for which I could figure out a general reform only rather than some concrete and ready-to-apply reform only due to the lack of experience. Here are the shortcomings I found and the reforms that I have come to recommend.

3.1

PROVISIONS SHOULD BE THERE FOR THE TAXATION OF AGRICULTURAL INCOME

The Section 41 of the Income Tax Ordinance, 2001 states that all agricultural income is exempt from Tax. Apparently the poor farmer should not be taxed, as they are already so poor that they cannot afford to

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reduce their income by any means. But the question over here is: Does agricultural income only relate to the farmers? If we look at the description of agricultural income given in the Ordinance, it does not by any means look like it is only for farmers. It is applicable to the strong Vaderas and the landlords too. Here I would relate the Ability-to-buy principle mentioned in 2.2. The tax liability of every person should reflect his ability to pay for the economy. Now, even if the poor farmers cannot pay, one can easily see that the rich landlords are richer than most of the people in the country. We can never have a balanced economy if such big revenue-earners are going unnoticed. The middle class salaried people have to pay on their behalf. The reform that I would suggest is that there should be some criteria set for the taxing of agricultural income. There should be proper tax slabs that apply to agricultural income too. We dont even need to make new slabs for this. The existing Income Tax Rates can be applied to the Agricultural Income too. Like this, the poor farmers will be excluded, as their income wont fit into any slab. And the Jageer-dar type of people will automatically be taxed. So I would rather say that Section 41 needs to be amended. There can be two situations 3.1.1 Section 41 should either be excluded from Part VII Exemptions and Tax Concessions. It should only define the agricultural income and state that the same tax slabs as applicable to other heads of income. OR Section 51 should remain in Part VII. However instead of totally exempting the agricultural income there should be conditions specified i.e. if a person earns below this much or owns below this much land, then he is exempt. The amounts above that should be taxed, and the criteria for that should be mentioned.

3.1.2

I further read in an Article that the current taxation on agricultural income is a violation of the Article 260 of the Constitution. And if we tax the agricultural income accordingly there can be potential tax revenue of about Rs. 200 Billion. Agriculture forms 22 percent of the GDP, so we should not let it go unnoticed. And there should be reforms in this particular area, otherwise the economy and taxation of Pakistan wont remain balanced. These rich landowners will get richer and richer and the poor and the middle class will get poorer and poorer.

3.2

Control on the Indirect Taxation

A very common debate in taxation is Direct vs. Indirect Taxation. Indirect Taxation is playing Havoc in Pakistani Economy. These taxes are not only disturbing the individuals. They are also disturbing the business activity overall. There is a recession going on. So I would rather suggest that Indirect Taxation should be minimized. As stated by the FBR, at least 45% of the Tax revenue targets is not met. The reason is that our authorities are falling for the wrong categories. Although there are many advantages of using Indirect Taxation from an economic point of view, which I wont go into; but there are many havocs that indirect taxation is creating. Many of the people are unaware as to how much indirect taxes they are paying, and the major issue in Pakistan is that most of the indirect taxes are applicable on the necessities of life; things that you cannot stop using, which is bad. The 2nd thing, whose detail I wont go into is, that when indirect taxes are imposed (as per Mankiw in his Principles of Economics), when there are indirect taxes the seller tries to put the maximum tax rate on the buyer. This is against almost all the

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principles I mentioned in the Heading too. The big industrialists who have more ability to pay are somehow saved and the common man is affected, as he cannot stop purchasing necessities. It also violates the Transparency Principle because the taxpayer does not even know how much is the tax and how much is the actual sale price. I would give the suggestion of the following reforms on the Indirect Taxation issue 3.2.1 The Indirect Taxation imposed on the necessities should be minimal. More of the indirect taxation should be imposed on the facilities, but even this amount should be kept in check. The most application of indirect taxation should be on luxuries. Like this every individual would pay indirect taxes as per his social class Instead of putting focus on indirect taxes, there should be more focus on direct taxes, so that every individual knows how much is he paying, and the income taxes are according to the amount each individual is earning rather than imposing the same amount of tax for both the haves and have nots. Thus there would be more circulation of wealth. Plus these indirect taxes are way more aggressive than the direct taxes. They also boost up the inflation and reduce the economic activity, instead of flourishing it.

3.2.2

3.3

TAX RATES SHOULD BE SOMEWHAT FLAT

If you look at the Marginal Tax Rates, they are higher than the Average rates of Tax. Such practices even though are present all over the world have faced a lot of criticism. This type of tax structure leads to black practices in Tax. I would recommend that somewhat flat structure be adopted for taxation. Tax Rates should be revised, and although a totally flat structure is against the ability to buy principle, tax rates should be somewhat flat. The constant increase in tax rates leads to more tax evasion and hiding of income from the authorities. High top tax rates can induce counterproductive behavior and suppress revenues. Furthermore, the key assumption of static revenue analysis that economic growth is not affected by tax changes is disproved by the experience of previous tax reduction programs. There is little reason to expect static revenue analysis to evaluate the economic or distributional effects of current tax reform proposals. The main issue of the Pakistani society is that the richer people do not pay taxes. Only if we reduce their tax rates, there tax liability will fall considerably and there is a chance that the tycoons reduce their tax evasion and such practices. There are other things too that can avoid these practices, which will come further in discussion.

3.4

FEDERAL EXCISE SHOULD BE KEPT IN CHECK

I also went through the Federal Excise Act, 2005. There have been recent amendments in the duties of various things. The retail prices of items such have cigarettes have increased by rates as high as 7%, due to these duties. The thing is that just because you increase these liabilities on items people are addicted to; it does not mean people will actually start paying those duties or stop purchasing them especially the

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merchants dealing with these things. There are many cases that my dad tells, when various relatives and other friends are like Kindly get my cigarettes cleared from the Custom Duty. The question is what we are doing to our people through these ridiculously increasing rates. It is not just in Income Tax, it is on other stuff like too like the Federal Excise Issue I just mentioned. In this case I will give the following recommendations 3.4.1 3.4.2 3.4.3 Before deciding on rates, proper consideration should be made as to what rates should be applicable and what increments should be added Rather than increasing the Excise duties with large rates, we should rather keep a somewhat flat structure so that people avoid tax evasion There should be proper checks and controls on the collection of excise duties. Customs that is one of the most corrupt departments of our country should be properly supervised as to how honest they are with these duties. Other Government departments should have some intervention and there should be people supervising and analyzing the whole thing

The revenues from Federal Excise can be a big source of future Government ventures, but that is only possible if the people involved take it seriously.

3.5

COLLECTION PROCESS AND COLLECTION COSTS SHOULD BE WELL IN PLACE

Tax Planning and writing the Tax Law is important, but it does not work out if the Taxes are not paid and collected efficiently. The efficient collection is very important in fulfilling and applying the first principle of a good tax system that I mentioned in 2.1 i.e. the tax revenue raised should be enough for the government. Unfortunately in Pakistan this process is not that efficient. As quoted in the class; only 2% population is paying the tax for the entire nation. I would give the following recommendations for effective tax collection 3.5.1 3.5.2 The collection costs should be kept low so that it is easy to collect taxes, and there is no inefficiency on this basis. There should be proper checks and balances on the collection staff especially customs. As this is the sensitive issue, therefore I guess it is better to have more than one department involved. There should be proper checks on the collection process There should be proper guidelines on how to make our collection process more efficient. There should be provisions in law taking care of the fact, that the hurdles in the collection process are removed properly. All our Ordinances talk about rates and definitions and vague things, but a set plan or methodology is nowhere. There should be theoretical grounds for these things so that the guilty officials can be traced and held accountable

3.5.3

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3.6 TAX PLANNING AND TAX EVASION TYPE OF THINGS MUST BE SERIOUSLY TAKEN CARE OF

Pakistani Society has a lot of tax evasion and tax planning which is going unnoticed. I would devise the following recommendations so that tax planning and tax evasion is taken care of properly 3.6.1 The Income Tax Ordinance states that when someone transfers any asset to someone else in any tax year, it will be the transferor who will be taxed. But it does not say anything about the property etc. owned by the taxpayers children. These go unnoticed, and hence we need to devise a system in which the big industrialists etc. have to declare all such otherwise taxable items The fixed assets purchases especially at the end of the tax year should be properly verified, so that companies do not understate their profits by charging excess depreciation that does not exist. It is a common practice to show a purchase of some fixed asset at the end of tax year and hence there should be some way to avoid these sorts of fraudulent practices There are many sections in the Income Tax Ordinance, 2001 that are not clear and loopholes are there, which the tax evaders can take advantage of. The Ordinance should be revised to cover any such loopholes Like I said earlier, there should be a somewhat flat tax structure, so that people in high tax brackets are better willing to declare their real income and assets instead of adopting other things like Capital Gain and lack of proper disclosure

3.6.2

3.6.3

3.6.4

3.7

ISLAMIC PRINCIPLES SHOULD BE CONSIDERED

Although Pakistan is an Islamic Principle but like many other aspects, the application of Islamic principles is lacking in the field of Taxation as well. In Islam, there is Wealth Tax and the amount of tax a person owns depends greatly on the amount of Wealth he owns in order to help the poor people and facilitate the distribution of wealth in the society. You see an Islamic Society is a balanced one and it is in accordance with all the Principles of Taxation I mentioned in the heading 2. In the result of Islamic System of Taxation, the government is enough to raise enough money, the tax paid is according to the taxpayers ability, this money is spent on the welfare of people and this system is transparent and clear. Even the caliphs used to pay their money into the Bait-ul-maal, but what is happening today in Pakistan? I think none of these principles is being acted upon. I know it really is not my level of experience and knowledge to devise ways for the Islamization of the entire Tax system. But I would recommend that indirect taxes should be controlled, because they highly distort the economy if there in excess and affect the poor man the most. Again everyone should be held accountable to the state including the heads of the state. And I did talk about a somewhat flat tax rate structure, but it should have variations too as per the income range, but should not vary as much as the amount forcing the rich people to evade tax. If all the provisions I mentioned in the above headings are carefully implemented along with the application of Islamic Principles, our society can be a better one as per equitable distribution of resources, and there will be more circulation of wealth

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3.8 RIGHTS AND DUTIES SHOULD BE SPECIFIED IN LAW

Although the Income Tax Ordinance specifies the personnel and the institutions involved in Tax authorities and Tax collection, and the Federal Excise Act and the Custom Act also give some guidelines as to these stuff, but there is no proper description of rights and duties anywhere. Since the Commissioners and other peoples do not have written down duties, they are more likely to shirk work and to avoid much trouble for themselves. The rights and duties of the Tax authorities should be properly written down, so that they can be held accountable to the public in case of any issues. Our system needs to have proper checks and controls which is lacking

3.9

APPEALS SYSTEM SHOULD BE MORE EFFICIENT.

According to the CA Articles student, there are a lot of cases in which the companies are right, but they have to go into the cumbersome process of courts and appeals and stuff like that. It so happens that the Tax Authorities, instead of proper assessment, make careless mistakes for the sake of avoiding work. When the taxpayer finds out subsequently, he does file an appeal. And later on, there is a chance that he wins the case and he usually does, but there is a lot of wastage of time and money both on his part and the Governments part. This process should be revised and made more efficient. Plus like I said, the rights and duties should be properly specified so that any such individual can be held accountable.

REFERENCES
http://tutor2u.net/economics/revision-notes/a2-macro-direct-indirect-taxation.html http://thebeautifulpakistan.blogspot.com/2010/03/taxing-agricultural-income.html Principles of Economics by Mankiw: 4th Ed Joint Economic Committee, The Mellon and Kennedy Tax Cuts: A Review and Analysis, 1982. http://www.rafaqatbabar.com/downloads/federalexcise.pdf