The present income tax mechanism in Pakistan is based on an opt-in strategy. An individual has to first go through a cumbersome registration process with the FBR and then only can they file their income tax return. Such a mechanism would be a hard sell even in a developed country where a significant portion of the economy is documented. To make it work effectively in Pakistan is a Herculean task. Despite repeated attempts to expand the tax nett, the numbers remain paltry and do not inspire much confidence in the existing setup. It is time to re-think the income tax mechanism, co-opt the family structure into how returns are filed, and bring statistical techniques to bear on the issue of tax avoidance.
Although in the recent budget, the government tried to move past the filer and non-filer binary by introducing the Active Taxpayer List, the income tax mechanism is still based on opt-in. Asking individuals to register before paying their income tax disincentivises filing. Moreover, allowing individuals with incomes below a certain threshold to not file at all means that income tax filing can never become part of the national psyche and transform into the robust institution it ought to be. Recently, the FBR has reduced red tape by letting individuals file using their CNIC number as the NTN. However, without requiring every citizen with a CNIC to file income tax, even if the payable amount is zero, the move will have limited success.
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Moreover, even with changing demographics, a large number of women are not part of the labour force, formal or otherwise. As per the Labour Force Survey 2017-18, the labour force participation rate for females is a paltry 20.1%. Consequently, many women do not file an income tax return and are not part of the tax net. However, this is a loophole in the existing tax code. Often properties and cars are registered in the name of the female members of the household since the male breadwinner has underreported his income. By requiring all citizens to file taxes using their CNIC number, entire families will become part of the tax net. As a result, the ability to keep so-called “benami” assets will diminish.
At first, requiring everyone with a CNIC to file taxes may seem like a tedious exercise, but it need not be as exasperating. The tax code should allow for joint- and dependent-filing. For example, in a family of four, including a stay-at-home spouse and two dependent children, the primary breadwinner should file a return jointly with the spouse and list the latter and the children as dependants. Moreover, retired parents living in the same household could also be included as dependants. The FBR should reformulate the tax brackets such that the basic exemption, Rs600,000 under the recent budget for salaried individuals, should increase as the number of family members on the return increases. This way, the FBR can incentivise the entire family unit to be in the tax net, encouraging documentation, and track familial income and wealth dynamics over time. As a by-product, stay-at-home spouses, usually women, will also become part of the formal economic system. They will not have to explain themselves as to why they are not on the Active Taxpayer List.
The tax mechanism would also need to be further adapted to local conditions: many Pakistanis work in the informal sector either as an employee or on a self-employed basis. If employed in the informal sector, the employer should note the salary paid to the employee and state the latter’s CNIC number. Since all CNIC holders would be required to file tax returns, the FBR can verify whether the employer reported the correct wages using the return filed by the employee. Although such a procedure may sound far-fetched, the Edhi Foundation documents its donations in much the same way. A donor has to mail a copy of the receipt to the head office to close the loop. The crucial link in this chain is that every individual, regardless of income, has to file a tax return. Those earning below the minimum threshold of Rs600,000 should also submit to claim the basic exemption.
Of course, it is the business-people in the informal sector who pose the most significant problem as they either may not file the returns or underreport their income. By clamping returns to CNIC number, the FBR can clamp down on complete evasion. To detect underreporting the institution has to use statistical techniques. Even within our economy, some expenses tend to be identifiable. Plane tickets and visas are purchased using CNIC numbers. Fees for private schools and universities are in a student’s name; money sent abroad for education purposes is also documented in the banking system. Moreover, utility bills are associated with specific property units, and so on.
Consequently, the FBR can collect all these data points for each household and compare it to the income reported on the tax return. Authorities can accurately estimate the portion of income spent on schooling, travel, and other consumption and non-consumption expenditures using data for salaried persons. Armed with these numbers, the FBR can detect whether a self-employed individual in the informal sector is outspending someone in the formal economy with the same reported income conditional on demographic characteristics. If both are reporting the same earnings, but the self-employed person is spending orders of magnitudes more on his child’s education than the salaried individual, the FBR has reason to conduct an audit of the former. The ideas we discussed can be easily formalised using statistics and econometrics and are feasible to implement.
Unarguably, questions of privacy and data security come into play. This massive dataset should not be made public whatsoever. Similar to microdata from the census, it should be stored extremely carefully on local systems that are not online. Moreover, access to the data should be limited physically. For example, an FBR employee working with the data should not be allowed to take any electronic storage device with them inside the room that houses the computers.
In conclusion, we need to revamp our existing tax system if we are to avoid a debt crisis every five years. Fixing the loopholes in the income tax code to expand the tax net is an area that needs urgent attention. In the absence of an effective income tax mechanism, successive governments have focused on fiscal jiggery-pokery by imposing all sorts of regressive taxes. Property taxes and sales taxes are other causes of concern, especially the former. A multidimensional problem like that of our revenues requires a multifaceted approach. We have highlighted a line of attack for income taxes: mandatory filing at all levels of income, taxing households and not individuals and using statistical methods to detect evasion in the shadow economy.
Published in The Express Tribune, August 22nd, 2019.