Why don’t people pay taxes?


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ISLAMABAD: Taxes are levied through law and every citizen of the country is supposed to be a law-abiding citizen. However, Pakistan is one of the countries where the ratio of taxes to the size of economy remains quite low.

In fact, it is far lower than the spending ambitions and obligations of its federal and provincial governments.

One can always come up with an array of popular but evasive arguments, like lack of trust in the government; corruption and misuse in expenditure of public money; and tax agencies’ connivance with tax evaders. Yet, so many countries with a worse track record, on all these counts, are able to collect much more taxes.

In an ideal world, citizens expect an honest government and tax institutions, but in the real world, governments and their tax authorities are seldom likeable entities.

The problem is that compliance with tax laws and payment of taxes is quite counter-intuitive in essence. The human brain is trained to make trade-offs, that is, giving away something only on getting something of equal or greater utility in return.

Taxes on the other hand are not linked with any exchange or reward, in the short, medium or long term. As often, the beneficiaries of tax payments are sets of people, different and remote from those paying the taxes.

So, in a rational world, nobody would like to pay taxes, unless forced to. Let’s for a minute assume that an individual is patriotic and understands the national importance of paying taxes, and wants to be completely honest with the government in tax returns. If such a person is a salaried individual or is receiving passive incomes such as rents, dividends or interest incomes, such honesty is possible.

But in case of traders or manufacturers of non-branded goods, such honesty can grievously harm their business, if their competitors are not paying their taxes honestly.

The objective of the argument is not to condone non-payment of due taxes, but one needs to understand the rationality and logic behind non-declaration or under-declaration of revenues by the otherwise honest persons.

Let’s say in a tyre trading market, there are 50 shops selling car tyres. Two of these shops are registered as sales tax filers. If the cost of one tyre to all shopkeepers is Rs8,500 and each of them wants to earn a profit of Rs1,500, the sale price of tyre will be Rs10,000.

The sales tax-registered shopkeeper will have to sell it at Rs11,800 because of 18% sales tax whereas the non-registered ones can sell it at Rs10,500 (if the cost of evading registration and filing is assumed at Rs500).

As a result, the ones registered with sales tax authorities will be forced to close down, unless they start under-reporting by suppressing sales or by buying flying input invoices, to the point where their selling price becomes at par with that of the tax-evading shopkeepers.

That is precisely the reason why the deepening of tax base is not possible without sufficient broadening, so as to establish horizontal equity, without which no tax enforcement can work.

The other dilemma in tax compliance is that a rational person would always like to minimise his tax payments, as the utility of money in possession is far greater than giving it to the government for a largely undetermined purpose (at least not determined by the taxpayer directly).

This paradox was elaborated by two economists namely Michael G Allingham and Agnar Sandmo in their 1972 seminal paper titled “Income tax evasion: a theoretical analysis.”

In this paper, they discuss the choice of a taxpayer who rationally trades off the benefits from evading taxes and the risk of costs from detection and incurring fines. It was argued that by increasing the perception of an increased probability of being caught (for evading taxes) and the magnitude and certainty of suffering penalties, tax authorities can deter evasion.

If we accept the robustness of this famous A-S Model of tax compliance, we can safely say that the tax authorities in Pakistan have not been successful in creating a perception in the minds of potential and actual taxpayers that paying taxes correctly now is far cheaper and painless than paying later, when their tax evasion stands detected.

The authorities have also not been able to create the perception that the probability of being caught, if one is not honest in compliance, is close to certainty.

According to available data, there are, in Pakistan, 160 million mobile phone users, 85 million bank accounts (67 million active bank accounts), at least 5 million private vehicles on roads, 350,000 industrial electricity connections and 4 million commercial electricity consumers, while the income tax filing population is 3.5 million (one-third filing zero income returns) and sales tax payers/ depositors are 60,000.

This is the perfect picture of an extreme horizontal inequity, which forces the people, who are filers/ payers, not to declare their revenues and incomes, correctly. The horizontal equity can be restored only if their competitors also comply.

This leads us to another interesting point. If the tax administration is not so effective, then why and how is it expected to collect almost Rs7.5 trillion in this financial year?

This is so because, luckily, an elaborate system of withholding taxes and tax collection on formal imports (customs duty, sales tax and income tax) is going to contribute about Rs5.5 trillion this year and most of the balance amount will be contributed by large corporates in the form of advance income tax and domestic sales tax.

This system has evolved as a result of our peculiar political economy and reluctance of allocating reasonable resources to the FBR. The system, though partially effective, is not encouraging tax base broadening or deepening because of the lack of horizontal equity and deterrence.

Moreover, compliance has become dependent on ad hoc tax deductions at various points of value chain, and the documented large-scale manufacturing sector.

The ineffectiveness of voluntary compliance by individuals and firms, on the other hand, is obvious from the fact that only Rs75 billion, out of this year’s annual target of Rs7,500 billion, that is, only 1%, represents the return payment.

So unless the tax authorities bring most of the liable persons within the folds of tax-paying population (horizontal equity) and successfully create a perception of a very high probability of being caught if not reporting correctly, with almost certain punitive consequences (effective deterrence), the potential and existing taxpayers are not going to pay their correct due taxes.

The matter of making procedures taxpayer-friendly and facilitation of taxpayers can come later, only after the fulfilment of these two primary and more important pre-requisites of horizontal equity and effective deterrence.

The writer is Revenue Lead, Revenue Mobilisation, Investment & Trade Programme (ReMIT), ex-member policy FBR, ex-additional secretary, Ministry of Industries and Production

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