The 2013-2014 Budget should not be the yardstick to measuring the new Government’s performance or strategic direction on account of the short time period they had to finalise the budget proposals. However, the expected creativity was found lacking, and the burden of State deficits was seen to be shifted to existing taxpayers, which, in the long run, is not the solution.
For years we have heard the rhetoric of “broadening the tax base”, which seems to have been falling on deaf ears. This could be either because the concept’s implementation methodology is not fully understood, or it is felt that taking tough measures to bring taxable economic activity into the net of collected taxes would be difficult in a country driven by social and political pressures. But the answer is fairly simple — document the economy, and do it in a way which benefits economic activity.
The classic example is that of corporatisation of businesses. 16th century Europe cashed in on this decades ago. Register businesses by introducing a fair system of taxation which motivates businesses to file tax returns, and in the process document the economy. If incorporated, individuals can also take advantage of limited liability, hence shared risks and easier access to finance.
Yet, despite the corporatised form of business dominating the developed world for the last few centuries, we have only managed to corporatise only 2% of our businesses. Around 63,000 businesses out of an estimated 3 million operate in the form of a company structure. At 9% Tax to GDP ratio, it is clear that a vast majority of businesses are outside the tax net. Resultantly, the advantages to the State, as well as to the individuals are lost.
A strong business corporatisation drive will lead to an economic model in which all businesses, irrespective of their size, sector or form, will contribute a share of their profits to the exchequer which can provide the State an opportunity to reduce taxes and grant relief to the public at large. Changes in duties and tax rates alone will not help us take this ratio to a level of 15% or higher. Something more needs to be done.
Once we realise that ‘something’ needs to be done, the nextquestion is: ‘what?’ The first, and most obvious answer is political will. After recognition of this need, achieving an incorporated Pakistan over the next five years is quite a doable task.
The second is already being worked on — the Corporate Laws Review Commission established in 2006. During my tenure as Chairman SECP, we had set up a dedicated secretariat to give impetus to this project, and to complete the research on and drafting of a new Company Law. Till date, we have been making ad hoc amendments to the existing Company Law. The proposed law is to be developed on specified principles, including the simplification of processes of registration, development of audit standards, giving investors a wider array of corporate structures, and moving towards a regime of proportionate regulation and enforcement without hassling the investors.
The third, and related requirement is that of taxation. Presently, incorporated entities pay taxes at a rate of 35%, while being subjected to greater audit and regulatory requirements than unincorporated entities; whilst partnerships and individuals pay tax at a rate of 25%, with little or no reporting or regulatory requirements. How then are we incentivising documentation? There is a historical justification for this anomaly — the decision to encourage small businesses, which may have been right at the time that it was taken, but the need of the hour is greater incorporation of businesses. Today, the same objective can be achieved by regulating entities in proportion to their size, as opposed to discouraging incorporation by levying higher taxes.
Fourth is the right regulatory environment. If our businessmen feel more comfortable investing abroad because it saves hassle and the possibility of unfair treatment, then we are doing something wrong. There has to be a revamp of the regulatory structure in Pakistan, especially in terms of development of HR. Austerity measures should never compromise the quality of HR.Our talent needs to be given better exposures, and foreign regulators need to be invited to Pakistan to impart skills, knowledge and ideas. This, coupled with market based compensation packages and performance based work environment, will minimize the potential for misuse of power by the regulators. It would also expose the regulators to their role in developing the economy of Pakistan, as opposed to merely policing it.
Last, an acceptable rate of taxation needs to be ensured. The basic principle driving higher collection of taxes should be that if the government needs more money, it should encourage people to make and declare more money rather than avoid investing, and try and hide profitability to evade taxes. The classic example is that of Far Eastern and Middle Eastern countries, which have kept the tax rate low but enforced it strictly, and their businesses are willing to pay the taxes as they are perceived to be fair. If we were to reduce our tax rate further and ensure that all businesses in Pakistan, irrespective of their form and size, are registered and subject to taxes, will we be better off or worse off?
Going forward, we also need to rethink whether tax rate should be a function of the form of business or its profitability. The latter would be a more plausible answer — a business earning a lower level of absolute profit should be subject to a lower tax rate irrespective of its form, especially when its accounts and operations are more transparent, is subject to greater regulatory scrutiny and is therefore less likely to be able to evade taxes. Therefore, the Federal Government should consider taxing corporations at a rate which is lower than other forms of business. To avoid the possibility of tax loss in the short term, the transition can be phased out over the next few years.
These recommendations are neither difficult to execute, nor will they require a lot of courage. But they do require political will — and from the gradual reduction of the corporate tax rate in this year’s budget, it seems that the will does hopefully exist.