Tax reforms: a new approach

By Dr. Ikramul Haq

All economists agree that a good tax system is one that raises money with minimal distortion to
the economy. In Pakistan, the tax system is the main source of many distortions in the
economy. We need a fresh approach to reverse the negative role of taxation to achieve higher
growth in economy. It is imperative to lower marginal tax rates and broaden the tax base with
few, if any, tax exemptions.

The taxation system should be simple and must keep down the cost of compliance and
monitoring. Our current system is monstrously complicated, and the cost of complying with
taxes is extremely high.

According to the official version, the total revenue collection by the Federal Board of Revenue
(FBR) for FY 2016-17 was Rs3362 billion. The FBR missed the tax target by a wide margin of
Rs259 billion. According to the chairman of the FBR, the shortfall was due to concessions given
by the government: Rs111 billion on account of reduced GST on oil products, Rs16.5 billion on
fertilisers, Rs11.5 billion due to textile package, Rs28 billion for zero-rating of five export-
oriented sectors and relief of Rs2.7 billion on pesticides. The FBR chairman, however, did not
mention the leakages in revenues due to corruption and inefficiency. He also did not mention
the higher cost of compliance for citizens: 90 percent collection was through withholding.
Pakistani policymakers must reduce the cost of collection and reliance on withholding taxes to
boost businesses and investment.

The chances of radical tax reforms in Pakistan are very slim as the main stress of the
government is on raising money through a higher rate of taxes, rather than using taxation as a
social policy tool. Successive governments, military and civilian alike, have never thought of
using refundable tax credits as the chief form of income support for the working poor – as is the
case in many countries, notably the US. When American politicians want to encourage home
ownership, purchase of health insurance or attendance at college, or merely to help a favoured
industry, they reach for tax breaks as a tool to boost the economy. There is a need to learn a lot
from the Americans on this front. For example, the introduction of alternate minimum tax
(AMT) revolutionised the entire American tax system.

In January 1969, the US treasury secretary informed Congress that 155 taxpayers with incomes
exceeding $200,000 had paid no federal income tax in 1966. The news created outrage. That
year, members of Congress received more constituent letters about the 155 taxpayers than
about the Vietnam War. Congress subsequently enacted an ‘add-on’ minimum tax that
households paid in addition to regular income tax. It applied to certain income items
(‘preferences’) that were taxed lightly or not at all under the regular income tax. The largest
preference item was the portion of capital gains excluded from the regular income tax.

Congress enacted the modern alternative AMT in 1979 to operate in tandem with the add-on
minimum tax. The AMT is a little-known back-up to the income tax which is designed to ensure
that rich Americans don’t avoid paying income tax entirely by claiming too many deductions. It
allows fewer deductions than the normal income tax (mortgage interest, donations to charity
and a few other things). It is also less progressive, with two rates of 26 percent and 28 percent,
levied on incomes above a certain, tax free amount, which in the case of a married couple has
long been $45,000. Under the present American law, US citizens (or resident non-US citizens)
have to pay either income tax or AMT, whichever is higher.

We must also introduce something like the AMT to tax rich Pakistanis, who at present are not
paying any income tax due to excess deductions, reduced tax rates or exemptions such as those
on agricultural income, gains on immovable property and shares listed on stock exchanges. In
the Pakistani scenario, where the tax base is dismally narrow, the AMT could be used as a
vehicle for tax reforms. The AMT can be made more progressive – retaining the most popular
incentives of today’s income tax, without bringing in all the more outrageous exemptions.

In 2004, Michael Graetz, a tax expert at Yale University, came up with an innovative way for
simplifying the American tax code dramatically. He suggested replacing income tax with the
AMT, but with an exemption of $100,000 per family and single rate of 25 percent. With a
$100,000 exemption, only 25 million people were to pay income tax. To make up for the lost
revenue, Graetz suggested introducing a value added tax between 10 percent and 15 percent.
This could shift the tax base towards consumption rather than income, and would thus be
friendlier to saving. Marginal rates would be low and the system would be simpler. To retain
progressivity and mitigate the impact on the poor, Graetz suggested that poor Americans could
get tax relief on their contribution to ‘Social Security’. We should consider this model for
Pakistan as well.

Pakistan certainly needs to clean up its tax system. If Prime Minister Shahid Khaqan Abbasi is
really serious about generating revenues and boosting exports, tax reforms are indispensible.
He must prepare a bill for immediate withdrawal of all exemptions in tax codes and bring the
rich Pakistani under the AMT. The VAT system should be rationalised by reducing its rate to 10
percent with no exemptions. The end consumers should be given a facility to get a refund of
two percent on production of evidence of payment of VAT and no question would be posed
about the sources of expenses. This will encourage documentation as they will invariably insist
for invoices on all the purchases.

The middle-class and poor people should be given tax cuts and benefits of a system of Social
Security as is prevalent in all democratic countries.