Tax Gap

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Tax- the Life Blood of the State: ³Taxation is defined as the process or means by which the sovereign, through its lawmaking body, raises income to defray the necessary expenses of government.´ Expressed in another way, ³taxation is the power vested in the legislature to impose burdens or charges upon persons and property for the purpose of raising revenue for public purposes.´ The nature of the state power to tax is two-fold. It is both an inherent power and a legislative power. It is inherent in nature being an attribute of sovereignty. It has been argued that it is literally impossible for the state to run its affairs without taxes. Its existence and operations are dependent primarily from the revenues and charges imposed from various sources. It is a legislative power because it involves promulgation and implementation of rules. Taxation is a set of rules, how much is the tax to be paid, who pays the tax to whom and when it should be paid. Government financial operations are well-nigh impossible without taxation. Apart from this, taxation can be a powerful means in order to achieve the goals of social progress and the objectives of economic development. It serves as a device to encourage the growth certain activities by way of giving exemptions, discourage use of certain products by way of imposing heavier charges like those taxes which are imposed upon tobacco products, or strengthen anemic enterprises, also by way of tax exemptions. Local industries may be protected through taxation by imposing high customs duties to foreign goods. Moreover, taxation can also be used to reduce inequities or inequalities in wealth and income by progressively higher taxes as in the case of estate and income tax. So based on the foregoing premises, it is clear that taxation is indeed the lifeblood of the state, without which the existence of the state will be put to jeopardy. TAX LAWS IN PAKISTAN: So, considering the above things, each country has developed rules to collect revenue from its public; Pakistan has also done legislation for this and at current the followings are observed to collect tax under various kinds (which will be discussed later in Section 2 Pakistan Tax Structure); A) Direct Tax:

1. Income Tax Ordinance, 2001 2. Income Tax Rules, 2002 B) Indirect Tax: 1. 2. 3. 4. Sales Tax Act, 1990 Sales Tax Rules, 2006 Sales Tax Special Procedures (Withholding) Rules, 2007 Sales Tax Special Procedures Rules, 2007

C) Federal Excise: 1. Federal Excise Act, 2005 PAKISTAN¶S TAX SYSTEM IN RESEARCH CYCLE: Pakistan¶s tax system has undergone significant reforms over the last two decades, leading to the modernization of direct and indirect taxes. More recent times have seen the rationalization of income tax rates, the introduction of self-assessment for filing income taxes, some expansion of consumption taxes, and the rationalization of the customs tariff structure with a reduction of tariff bands and maximum rates. The Federal Board of Revenue (FBR) engaged in a comprehensive plan to re-structure and modernize the entire tax administration and customs operations, and has taken steps in the recent past to increase the number of taxpayers and broaden tax bases. As a continuing effort to improve the tax system in Pakistan and complementing the ongoing work of the Tax Administration Reform Project, the International Studies Program was contracted by the World Bank and the FBR to conduct the Pakistan Tax Policy Review Project from 2007 - 2009. As part of the project, the ISP (International Studies Program, a fiscal policy research center that is part of the Andrew Young School of Policy Studies at Georgia State University) produced a series of policy papers to further analyze and evaluate the tax system in Pakistan, as well as to extract lessons from the international experience in tax reform in order to obtain specific policy recommendations. The final report provides a comprehensive assessment of Pakistan¶s tax policies and lays out options for reform. Both the final report and policy papers were a joint product of a team from the Federal Board of Revenue (FBR), Government of Pakistan, the Andrew Young School of Public Policy (AYSPS) at the Georgia State University, and the World Bank, which are listed as below; 1. Pakistan Tax Policy Report: Volume I 2. Pakistan Tax Policy Report: Volume II 3. Pakistan Tax Policy Report: Tapping Tax Bases for Development

4. Incidence of Taxes in Pakistan: Primer and Estimates 5. Pakistan: Comprehensive Individual Tax Reform 6. Pakistan's Tax Gap: Estimates By Tax Calculation and Methodology 7. Assessing Enterprise Taxation and the Investment Climate in Pakistan 8. Pakistan - A Globalized Tax World: An Analysis of its International Tax Practice 9. Tax Policy in Pakistan: An Assessment of Major Taxes and Options for Reform 10. Pakistan: Provincial Government Taxation Further, the following studies have also been done in the context to bring Tax Reforms and to evaluate the tax gap; 1. Ahmed, Robina Ather and Rider, Mark. Pakistan¶s Tax Gap: Estimates by Tax Calculation and Methodology. 2. Alm, James and Khan, Mir Ahmad. Assessing Enterprise Taxation and the Investment Climate in Pakistan. 3. Bahl, Roy, Wallace, Sally and Cyan, Musharraf. Pakistan: Provincial Government Taxation. 4. Martinez-Vazquez, Jorge. Pakistan ± A Preliminary Assessment of the Federal Tax System. 5. Michelse, Geerten. Pakistan ± a Globalized Tax World ± An Analysis of its International Tax Practice. 6. Thirsk, Wayne. Tax Policy in Pakistan: An Assessment of Major Taxes and Options for Reform. 7. Wahid, Umar and Wallace, Sally. Incidence of Taxes in Pakistan: Primer and Estimates ORGANIZATION OF THIS RESEARCH WORK: This research work has been organized into four (4) sections. Section no. 1 states the introduction of the topic, identifying problems, significance of the research work and the studies already done regarding this. Section no. 2 explains the tax structure of Pakistan, tax collection in Pakistan and its comparisons with other countries of the region.

Section No. 3 elaborates the term ³Tax Gap´, reasons, causes, effects and measures to minimize it. Section No. 4 discusses the tax reforms and challenges confronting FBR.

SECTION 2
PAKISTAN TAX STRUCTURE (TAX SYSTEM) Taxation System Federal taxes in Pakistan like most of the taxation systems in the world are classified into two broad categories, direct and indirect taxes. A broad description regarding the nature of administration of these taxes is explained below: Direct Taxes Direct taxes primarily comprise income tax, along with supplementary role of wealth tax. For the purpose of the charge of tax and the computation of total income, all income is classified under the following heads: 1. Salaries 2. Income from property; 3. Income from business or professions 4. Capital gains; and 5. Income from other sources. Personal Tax All individuals, unregistered firms, associations of persons, etc., are liable to tax, at the rates ranging from 0.75 to 35 per cent. Tax on Companies All public companies incorporated in Pakistan are assessed for tax at corporate rate of 35%. However, the effective rate is likely to differ on account of allowances and exemptions related to industry, location, exports, etc. Unilateral Relief A person resident in Pakistan is entitled to a relief in tax on any income earned abroad, if such income has already been subjected to tax outside Pakistan. Proportionate relief is allowed on such income at an average rate of tax in Pakistan or abroad, whichever is lower. Agreement for avoidance of double taxation The Government of Pakistan has so far signed agreements to avoid double taxation with 39 countries including almost all the developed countries of the world. These agreements lay down the ceilings on tax rates applicable to different types of income arising in Pakistan. They also lay down some basic principles of taxation which cannot be modified unilaterally. The list of countries with which Pakistan has concluded tax treaties is given below:

Austria China Finland Indonesia Japan Malta Poland Sri Lanka Turkey U.S.A Customs

Belgium Denmark Germany Iran South Korea Mauritius Romania Sweden Tunisia

Bangladesh Egypt Greece Ireland Lebanon Saudi Arabia Switzerland Turkmenistan Kazakistan

Canada France India Italy Libya Singapore Thailand U.K. U.A.E.

Goods imported and exported from Pakistan are liable to rates of Customs duties as prescribed in Pakistan Customs Tariff. Customs duties in the form of import duties and export duties constitute about 37% of the total tax receipts. The rate structure of customs duty is determined by a large number of socio-economic factors. However, the general scheme envisages higher rates on luxury items as well as on less essential goods. The import tariff has been given an industrial bias by keeping the duties on industrial plants and machinery and raw material lower than those on consumer goods. Central Excise Central Excise duties are leviable on a limited number of goods produced or manufactured, and services provided or rendered in Pakistan. On most of the items Central Excise duty is charged on the basis of value or retail price. Some items are, however, chargeable to duty on the basis of weight or quantity. Classification of goods is done in accordance with the Harmonized Commodity Description and Coding system which is being used all over the world. All exports are exempted from Central Excise Duty. Sales Tax Sales Tax is levied at various stages of economic activity at the rate of 17 per cent on: i) all goods imported into Pakistan, payable by the importers; ii) all supplies made in Pakistan by a registered person in the course of furtherance of any business carried on by him; There is an in-built system of input tax adjustment and a registered person can make adjustment of tax paid at earlier stages against the tax payable by him on his supplies. Thus the tax paid at any stage does not exceed 17% of the total sales price of the supplies;

PAKISTAN¶S TAX COLLECTION AND COMPARISON WITH OTHER COUNTRIES OF THE REGION:

SECTION: 3 TAX GAP; UNDERSTANDING, REASONS, EFFECTS: The ³tax gap´ is the difference between the annual amount of taxes owed and the amount voluntarily paid on time. Where does the tax gap come from? The tax gap comes from three main areas of non-compliance with the tax law: underreporting of income, underpayment of taxes and non-filing of returns.
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80 percent of the tax gap comes from taxpayers who either underreport income or overstate expenses. On improper returns filed by individual taxpayers, more than 80 percent understate income, rather than overstate deductions. Most of the understated income comes from small business activities, not wages or investment income. Why does the tax gap cost honest taxpayers money?

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The tax gap costs honest taxpayers money in three ways:
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It results in higher taxes. Honest taxpayers pay nearly 20 percent more in taxes due to tax cheating. Collecting the underpaid taxes takes time and costs money. Tax rates must be set higher initially in order to cover the shortfall that results from the tax gap. It increases the national deficit, which further increases taxes. It reduces the level and quality of government service that can be offered. What is being done about the tax gap?

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The International Revenue Service has devised in its research work named as ³Comprehensive Strategy for Addressing the Tax Gap based on four key areas:

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"First, unintentional taxpayer errors and intentional taxpayer evasion should both be addressed." The IRS (International Revenue Service) acknowledges that simplified tax return forms, instructions and procedures would go a long way toward reducing unintentional taxpayer errors, and they continue to work for improvement in this area.

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"Second, sources of noncompliance should be targeted with specificity." "Third, enforcement activities should be combined with a commitment to taxpayer service." "Fourth, policy positions and compliance proposals should be sensitive to taxpayer rights and maintain an appropriate balance between enforcement activity and imposition of taxpayer burden."

The yawning tax gap in Pakistan Report by Dawn: Published on February 14, 2011 THE tax gap ² the difference between sum of tax owed and amount of tax paid voluntarily and on time ² stands at 79 per cent of the actual tax receipts in Pakistan, according to Federal Board of Revenue Chairman Salman Siddique. This compares with the tax gap of nine per cent in the UK and 22 per cent in the US, he told the Supreme Court last month during the hearing of a case about pilferage of containers entering Pakistan¶s territory under the Afghanistan-Pakistan Transit Trade Agreement. Mr. Siddique¶s tax gap estimate is based on a study detailing the extent of tax non-compliance during the financial year 2007/08 and released by the World Bank in September 2009. The report ± Pakistan Tax Policy Report 2009: Tapping Tax Base for Development ± pointed out that the total tax evaded in 2007/08 stood at Rs. 796 billion against a collection of just over Rs. 1.1 trillion. Dr. Ikram ul Haq, a tax Expert, told, ³Only 2.4 million people (out of a population of 180 million) file their tax returns. ³This is shameful.´ He further contended, ³The tax gap ± which arises from tax evasion, avoidance and exemptions (given to certain groups like rural land owners and urban property holders at the cost of the others) ± underscores collection inefficiencies and defective and inequitable tax policy,´ The World Bank report, too, emphasized the same, saying, ³There is a broader consensus that the country¶s tax system under performed as it has a narrow base, with taxes being levied on a limited number of sectors, businesses and individuals. A large tax gap suggests that the tax system is likely to under perform in terms of revenue, efficiency, equity and administration.´

Rampant tax pilferage explains the main reason for the country¶s tax-to-GDP (gross domestic product) ratio of less than nine per cent, one of the lowest in the world. Only a fraction of taxes ³illegally evaded or legally avoided (in the form of exemptions)´ can be recovered through initiation of legal proceedings against the tax cheaters. ³This involves a cumbersome legal process and we are rarely able to recover the exact unpaid amount of taxes after delays of months and years because of lacunas in the laws, social and political pressures and widespread corruption (in the FBR),´. It is difficult to state the exact size of tax pilferage. Further, any increase in the collection of tax revenues in absolute terms did not signify actual reduction in the tax gap. It simply means that the government might have imposed more indirect taxes to push its collection and protect the affluent segments of society. Indirect taxes are bad for the people because it forces many to pay taxes even though they shouldn¶t be paying any. These also have implications for the economy and may retard growth. Tax experts say, the reasons for tax pilferage are numerous. While some may evade taxes because of personal greed, others escape paying their share because of a lack of documentation of the economy and the fear of accountability/punishment. Some may under report their incomes because of high tax rates and absence of incentives for honest taxpayers. Lack of political will for stricter enforcement of tax laws, departmental corruption and inefficient collection machinery also contribute significantly to the anti-tax culture. The implications of tax pilferage for the economy and society can be serious and far-reaching. It leads to huge losses to the government revenues, which are crucial for meeting its development and non-development expenditure requirements, and encourages black economy. Additionally, say the experts, it causes accumulation of wealth in fewer hands and promotes wasteful consumption. More importantly, Dr. Ikram ul Haq argued, ³the tax pilferage and exemptions were an incentive for speculative investments. The taxes are not merely a tool for revenue generation for the government alone. These are also an important tool for discouraging certain activities in the economy and encouraging the others. In Pakistan the taxes discourage productive investments and encourage unproductive and speculative investments in property, etc. Who would want to work hard and invest in the industry or other productive sectors if he can earn tax-free income through speculative investment in property?´ he asked. He was of the view that the inequitable tax exemptions, particularly on property transactions and rental income, led to unproductive investments and imposition of inequitable taxes on productive economic sectors as well as on people who should be getting tax subsidies. ³We cannot measure exact tax gap because we are unaware of the country¶s tax potential. But we can say with certainty that the tax gap is created to benefit the wealthy and the powerful.´

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