Direct tax policy principles: a review-I By MOHAMMED ASHRAF

ARTICLE (May 22 2007): TAXES - a source of Public Finance: Taxes are essential to finance public services, but there are good and bad ways to collect them. The design of the tax system can have a significant economic impact and can influence the residents of a country and multinationals in deciding where to invest.

Tax collection has long been a despised activity. But taxes are essential. Without them there would be no money to build schools, hospitals, courts, roads, airports or other public infrastructure that helps business and society to be more productive and better off.

TAX REGIMES:
There are two types of tax regimes - complex and simple as there is no third type.

COMPLEX TAX REGIMES: Tax regimes, with relatively high marginal rates and which include a number of exemptions and allowances, tend to be less economically efficient in relation to encouraging employment, saving and investment. Such regimes generally also impose higher tax compliance and administration costs which is evident from the Income Tax Ordinance, 2001.

We have experienced Acts of 1918 and 1922, which have lead to the basis of the creation of the Income Tax Ordinance, 1979, however, the Income Tax Ordinance, 2001 was created to make things simple. We know from our experiences about acts and ordinances, burdensome tax systems served as a deterrent and normally lead to tax evasion. According to a World Bank survey, Companies in 90% of surveyed countries [175 countries including Pakistan] rank tax administration among the top five obstacles to doing business.

THE MAIN FACTORS CONTRIBUTING TO THIS ARE:

1. The large number of business taxes to pay

2. Lengthy and complex tax administration

3. Complex tax legislation

4. High tax rates

SIMPLE TAX REGIMES: Evidence suggest that simpler tax systems promote economic growth and can help achieve a win:win for the government and industry. To help with paying taxes and implementing reforms, the government and CBR need to consider all aspects of the tax system. All taxes borne and collected by businesses should be recognised, alongwith the related tax compliance costs not just federal taxes.

IMPACT OF TAX RATE OVER COMPLIANCE: In the ongoing reforms, tax administration and compliance, being significant an obstacle to businesses, needs to be considered as part of the decision on reform. One should not loose sight of the fact that the government imposes taxes to finance public services, but taxes must first be collected and high tax rates do not always lead to high tax revenues. However, the larger the share of informal business activity before reform, the higher the revenue growth after, and it is evident in Pakistan.

On average, Middle Eastern and East Asian countries make paying taxes the easiest. OECD countries impose the smallest administrative burdens and charge moderate tax bills. According to a World Bank study, between 1982 and 1999, the average corporate income tax rate world-wide fell from 46% to 33% while corporate income tax collection rose from 2.1% to 2.4% of national income [Hines (2005)].

This outcome was achieved because more businesses entered the formal economy and because tax exemptions and other tax incentives were reduced or eliminated.

Developed countries tend to have lower business taxes and less complex tax administration processes. Simple moderate taxes and a fast, cheap administration mean less hassle for businesses - as well as higher revenues.

In contrast, Developing countries tend to use business as a collection point, charging higher business taxes. Latin American and South Asian countries impose the heaviest burdens, mainly because of high compliance costs. Africa follows, largely because of high taxes.

As stated earlier, Developing countries try to levy the highest amount of tax on businesses on the premise that these high taxes are needed to fund public services and correct fiscal deficits. However, the evidence suggest otherwise. Higher rates typically do not lead to higher revenues in developing countries. Instead, they push businesses into the informal economy. As a result, the tax base shrinks and less revenue is collected.

Lower rates work best when their administration is simple. Growing evidence shows that tax reforms creates more vibrant businesses and this is evident in Pakistan. A smaller tax burden encourages firms to invest. However, they are undermined by exemptions that the shrink tax base. I would like to share an adverse experience, tax revenues has fallen in Uzbekistan, where the enthusiasm for income tax cuts was not matched by efforts to improve tax administration and expand the tax base.

RECENT REFORMERS TAX RATE CUT AND HIGHER REVENUE TARGET:

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Ghana Exceeded its mid-year revenue targets
Despite significant cuts in Corporate
tax rates in the last two years
Albania Corporate tax revenue rose 21%
after the rate was cut
Moldova Corporate tax revenue rose 28%
after the rate was cut
Latvia Corporate tax revenue rose 37%
after the rate was cut
Romania Corporate tax revenue rose 8% in real
Terms after cut in tax rate In 2004
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Economic growth in these countries is a factor in the increased revenue but compliance is also up [Source: World Bank (2006)]. Overall growth is also higher with lower taxes and better collection [Lee and Gordon (2004)].

Overall growth is also higher with lower taxes and better collection. And with tax incentives aligned to encouraging work, more firms and more jobs are created. One study shows a cut of one percentage point in corporate tax rate is associated with up to a 3.7% increase in the number of firms and up to 1.1% higher employment [Goolsbee (2002)]. Tax reforms inspire political debate and can be hotly contested. But both businesses and government benefit when taxes are simple and fair and set incentives for growth.

TRANSPARENCY and CORRUPTION: Transparency is the key - Governments need to be accountable for how taxes are spent. Businesses will potentially be more willing to pay taxes if they can see the benefits of improved public services and infrastructure.

Businesses are more willing to pay taxes if they see that the money is used to improve public services. Yet many developing countries with high tax rates fail to improved business infrastructure or education and training - two things that employers care about.

Across countries, higher taxes payable are not associated with better social outcomes, even allowing for country income levels. They do not increase government spending on health and education, raise literacy or life expectancy or lower child mortality, nor are they associated with better infrastructure and other public services.

Burdensome taxes do, however, generate other undesirable outcomes. They are associated with more informality, as entrepreneurs often choose to avoid the formal system altogether and operate underground. They also breed corruption as every point of contact between a bureaucrat and an entrepreneur could present a danger of bribery and confusion on voluminous, often contradictory, rules, which may create room for discretion.

Simplifying the tax regime by reducing tax rates and eliminating exemptions is the main way to reducing corruption in the tax administration. According to a World Bank survey, Georgia introduced major reductions in tax rates and simplifications to the tax system in 2004 - and has seen a drastic fall in perceived corruption of tax officials. Georgia showed the sharpest drop in perceived corruption among 27 transition economies.

RECENT REFORMERS - TAX RATE CUT AND CORRUPTION:

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Georgia - Previous level 44% Current level 11%
Romania - Previous level 14% Current level 8%
Slovakia - Previous level 11% Current level 5%
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[Source: World Bank (2006)]

All the above referred factors, tax rate cut and corruption, tax rate cut and transparency, tax rate cut and increased compliance etc present a good case for reduction in corporate tax rate.

TAX COMPLIANCE COST: Businesses need to understand and communicate their total tax contribution, so that they are more able to manage and control it and demonstrate the full extent of their contribution made to public finances. I would suggest using indirect tax expense and taxing compliance cost as a separate head of expense in the profit and loss account instead of rent, rate and taxes.

A better way to meet revenue targets is to encourage tax compliance by keeping rates moderate. Russia's large tax cuts in 2001 did exactly that. Corporate tax rates fell from 35% to 24% and a simplified tax scheme lowered rates for small business. Yet tax revenue increases - by an annual average of 14% over the next three years. One study showed that the new revenue was due to increased compliance [Ivanova, Keen and Klemm (2005)].

It is not just businesses that gain from reforms. Streamlining taxes also brings savings for the government. A complicated tax system costs a lot of money to run - funds that could be better spent on education, health care and infrastructure. In Denmark, one Kroner spent on tax administration generates 113 Kroner of tax revenue. In Hungary, one forint produces only 77 and in Mexico one peso produces only 33. Such data is missing from performance measurement and must include the loans and grants received.

COMPLEXITY AND ITO, 2001: A particularly worrying consequence is that with the sheer volume of tax legislation, no one individual can possibly read all of it. So the days of a tax director being confident of spanning all the relevant parts of the tax code seem to have all but disappeared. Embodying all previous SRO's of section 50 of Income Tax Ordinance, 1979 by virtue of section 239 (10) did the rest.

Similarly, at least as regards advising large to medium size corporate bodies, the ability of a single tax advisor to span all the relevant tax legislation is circumscribed, hence, increased relevance of specialists and sub-specialists.

This leads to an at least two tier market - those who can afford the necessary advice, and those for whom such advice may be of only marginal benefit, on a cost/benefit analysis. It is also leading to a situation where the primary tax legislation is being read by fewer and fewer people.

The boldest reform is to simplify tax law so that every business faces the same tax burden - with no exemptions, tax holidays or special treatment for large or foreign businesses. Income Tax Ordinance, 2001 has also started in that way! But when hard times come and government needs revenue, tax rates are froze at the current level.

This is unpopular, and large or well-connected businesses usually obtain special treatment. Soon the tax law becomes riddled with exceptions, generally at the expense of small businesses, which have the least ability to lobby.

Often they are pushed into the informal sector. Few reformers dare eliminate exemptions, like Egypt - 3000 Exemptions.

To conclude, the Central Board of Revenue needs to reflect on the likely deterrent effect of the ever increasing complexity of the Income Tax Ordinance, 2001 and the resulting probable reduction in their international competitiveness. Ultimately, when tax legislation becomes too voluminous, compliance drops more through ignorance than deliberate evasion.

SIMPLER TAX REGIME with CONSOLIDATED TAXES:

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Number
---------------------------------------------------------
Corporate Income Tax Payments 5
Labor Tax Payments 25
Other Tax Payments 17
Total Tax Payments 47
Hours
Compliance Time - Corporate Income Tax 40
Compliance Time - Labor Tax 40
Compliance Time - Consumption Tax 480
Total Compliance Time 560
Corporate Income Tax - Average 27%
Statutory Corporate Income Tax 37%
Labor Taxes - Average 14.6%
Other Taxes 1.8%
Total Tax Rate 43.4%
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Consolidating taxes is also a worthwhile reform.

For instance, Pakistan has more than one labour tax, yet such taxes are typically based on gross salaries, why not unify them? Tax offices can then distribute the revenues among government agencies Slovakia did just that.

A practical problem arose in many countries where social security agencies here reluctant to part with their powers - especially if there was a chance that tax offices won't give them their share of revenue.

To gain their trust, an automatic separation of revenue can be introduced so that there is no room for discretion through codes on tax payment receipt. Moreover, stamp duty needs to be collected by the Central Board of Revenue along with CVT on tax payment receipt.

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Recent Reformers - Cut in number of Taxes
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Georgia [2004] - Number of taxes from 21 to 9
Russia [2001] - Number of taxes from 20 to 15
Iran [Recently] - Number of taxes from 3 to 1
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[Source: Georgia Business Council Interview and FIAS (2004)]

Reforms should also target minor taxes like stamp duties - which cost money to administer but do not raise much revenue - or particularly distorting taxes. Small businesses have a particularly hard time dealing with multiple tax payments. Why not help them by making their interactions with the tax agency simpler? The Central Board of Revenue Chief should work with the federal and provincial ministries in this regard.

(To be continued)