TAXATION IN THE ECONOMY OF PAKISTAN

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TAXATION IN THE ECONOMY OF PAKISTAN
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ACKNOWLEDGMENT


First of all, we would thank Allah Al-mighty whose mercy and grace
allowed us to be a part of this prestigious institution and also provided us with a
chance to work on this detailed analysis of the Taxation in the economy of
Pakistan. It gives us immense pleasure to study our degree course from this
acknowledged and revered institution in Pakistan. It is by virtue of this
university and kind teachers that we have a launching platform to exhibit our
hidden talents and skills in the industry.
Last, but not the least, we are very thankful to Sir Imran Rawat who
provided us with the opportunity to engorge our grasp on such an important
topic. Taxation and its impact on an economy has indeed been a prime focus of
economists from a very long time. In order to understand the impacts of taxation
on the economy, it is pertinent to start off with the history of tax and the
theoretical foundations that are lying behind this concept. We are also indebted
to all other people who played an integral part in completing this assignment,
especially the librarians, who helped us in conducting secondary research.

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Analysis of the effects of Interest Rates
over Inflation of three different
economies i.e. Bangladesh, India and
United States based on the data of 21
years from 1990 to 2010
Taxation in
the Economy
of Pakistan
Overview and History of Taxation
and discussion over the framework
of taxation in the Economy of
Pakistan.
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ABSTRACT


One of the major sources of revenue generation for the governments to meet
their expenditures is Taxation. Every fiscal year, state government announces its
annual budget (Fiscal Policy) highlighting all of the expected expenditures that are
going to be carried out in the subsequent year. Once the expenditures are ascertained,
the government then decides to meet them through various revenue generating
measures and taxation is the most prime of them all.
State governments collect taxes in different accounts and heads. The motive
behind levying most of taxes is to generate revenue, however, this is not the case all
the time. In some cases, a tax is imposed for reasons other than the generation of
revenue i.e. to discourage trade, to reduce externality or to make the market work
more efficiently. In this assignment, we are going to highlight the importance of
Income Tax, different methods of its collection and its impact on the economy. The
framework of taxation in Pakistan, which is set up by Federal Board of Revenue
(FBR) would then be critically evaluated and appropriate recommendations would be
highlighted in the end of this assignment.

Keywords: Taxation, Fiscal Policy, Externality, Annual Budget
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TABLE OF CONTENTS


Title Page .i
Acknowledgment ...ii
Cover Page ........iii
Abstract .iv
Table of Contents ...v-vi
1. HISTORY & OVERVIEW
1.1 History of Income Tax Collection 1-2
1.2 Overview of Income Tax..3
1.3 Theoretical Explanation of Income Tax3-4
2. TYPES & METHODS OF TAX COLLECTION
2.1 Types of Taxes .5-6
a) Direct Tax.5
b) Indirect Tax..................................6
2.2 Methods of Tax Collection................................................... 6-7
1) Proportional Taxation..6
2) Progressive Taxation7
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3) Regressive Taxation7
4) Lump-sum Taxation.7
3. FEDERAL BOARD OF REVENUE
3.1 Introduction .....8
3.2 History of FBR9-10
3.3 Functions of FBR...11
3.4 Organizational Structure of FBR12
4. METHOD OF INCOME TAX COLLECTION IN PAKISTAN.13-14
5. ADVANTAGES & DISADVANTAGES OF TAX COLLECTION
METHOD IN PAKISTAN ...15-16
6. CONCLUSION & RECOMMENDATIONS
6.1 Conclusion .....17
6.2 Recommendations..18
7. APPENDICES
7.1 References .19
7.2 Secondary Sources .....19
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1
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HISTORY & OVERVIEW

1.1 History of Income Tax Collection
The origin of the word Tax dates back to early 13
th
century. The French
and Latin of the 13th century were credited with the first use of a word similar
to Tax. The French had Taxer and the Latin used Taxare to describe the
following acts: to estimate, to assess, or to touch repeatedly.
Tax, as we know it today, existed in various forms in different societies
throughout civilization. Kings, queens, chiefs, rulers, and people in authority
were responsible for imposing and collecting taxes from the people they ruled.
What was taxed, when it was taxed, and how much tax was imposed varied
from society to society. Here are some examples of what was considered taxable
in some societies:

EGYPT: In ancient Egypt, the Pharaohs imposed taxes on cooking oil
and they appointed tax collectors who were known as Scribes to oversee the
collection of these taxes. To make sure every citizen paid their share of taxes,
the scribes visited households to inspect (audit) the amounts of cooking oil that
was being consumed and to make sure that substitutes were not being used to
avoid paying the cooking oil tax.

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GREECE: The Athenians of Greece charged a tax referred to as
Eisphora on its people during times of war. Every Athenian was required to pay
this tax, which was used to pay for spears, arrows, crossbows, shields, and
armor that the soldiers required for war. This tax was considered as an
emergency tax and was cancelled once the war was over. Also, if they returned
victorious from the war with riches acquired from their defeated foes, the taxes
collected were refunded to the citizens. They were also noted for charging a tax
on all residents who did not have both an Athenian mother and father. The tax
was referred to as Metoikion.

ROMAN EMPIRE: The Ancient Romans appointed people, known as
Publicani, who went around the markets with wicker baskets, to collect gifts
that the people were forced to offer to the Emperor Caesar. These baskets were
called Fiscus Cesares, which means Caesars treasures. These Publicani were
not very friendly in their tax collection techniques and were greatly despised by
the peasants.

GREAT BRITAIN: In the 11th century, an Anglo-Saxon woman
named Lady Godiva agreed to ride naked on a horse through the streets of
Coventry, if only her husband, Leofric, Earl of Mercia, promised to reduce the
high taxes he was charging the poor peasants.
In 1800, the British gave birth to what later became the modern day
income tax. The tax was imposed to pay for the war with Napoleon. Sixteen
years later, opponents of the law forced it to be abolished and demanded the
destruction of all documents that made reference to the law. However, a copy
was saved in the basement of the British tax court and was later revived to
become the model of modern day tax system.
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1.2 Overview of Income Tax
People often gets confused between different types of taxes. However, it
is quite simple to demarcate between Income Tax and all other kinds of taxes.
Income tax is a fee levied by the government on its every citizen who have a
positive income or who has earned a profit. It is the only tax, which is
conditional to the income of the tax payer and is only to be paid if the income is
above a certain level set up by the government.
Income tax was first collected in 18
th
century and since then it has been
collected in almost every country of the world. Although, the collection method
and the framework differs from country to country, nevertheless, the basic
structure is almost analogous.
In many countries, income tax is used as a tool by the government to curb
down the vast income inequalities. By imposing a fair amount of income taxes
upon the high income citizens, the government than redistributes the income by
spending on Public goods, resulting in more equal distribution of wealth among
the citizens.

1.3 Theoretical Explanation of Income Tax
In public economics, there are several theories on income tax that define
the criterion of imposing an optimal income tax. Nonetheless, the details of
taxation are guided by the two important principles of Who will benefit? and
Who can Pay. These important principles are discussed in the famous theories
i.e. The Ability Theory & The Benefit Theory.
Income tax is actually collected by the government from the tax payers
who are eligible by definition to pay the taxes. It is the biggest source of
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revenue generation for the government to meet the expenditures. The imposition
of tax is generally considered as the transfer of the purchasing power from
private agents to the public agents. The public agents then utilize the generated
revenue in carrying several welfare projects that could generate maximum
possible social welfare.
The theories of optimal taxation has been redefined by Mankiw, Rosen &
et. al. stating that the optimal tax is the one that could not only provide benefits
to the society but could also minimize the loss of social welfare.
With reference to our discussion over the income tax, the theory that
defines the optimal income tax collection is the Laffer Curve, which shows the
taxable income elasticity i.e. how much taxable income would respond to the
change in tax rate. It uses the extreme value theorem to determine the optimal
tax income tax rate.



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2
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TYPES & METHODS OF TAX
COLLECTION

2.1 Types of Taxes
Taxes are generally classified into two main categories that are defined as
follows:

a) Direct Tax
A direct tax is a non-transferable tax which is only to be paid by the one
on whom the tax is imposed. The burden of a direct tax cannot be shifted to
anyone else, which is the reason why they are termed as direct taxes. The types
of taxes that comes under the umbrella of direct taxes are listed below:
Income Tax: A tax which is imposed on the individuals income
Corporation Tax: A tax which is collected on the profit earned by the
corporations
Capital Gains Tax: A tax which is collected on the profit earned by the
sale of non-inventory assets.
Property Tax: A tax which is imposed on both the movable and
immovable property of an individual. Stamp duty is also a sub-category
of Property Tax.


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b) I ndirect Tax
An indirect tax is just opposite of the direct tax and is transferable in
nature i.e. it can be shifted to others and is not necessarily to be paid only by the
person on whom it is imposed. The burden of an indirect tax is mostly shifted
upon the ultimate consumers by the suppliers. The types of tax that come under
the umbrella of indirect tax are listed below:
Sales Tax: A tax which is imposed on the sale of a commodity.
Custom Tax: A tax which is imposed on imported and exported goods.
Excise Tax: A tax which is imposed on the producers at their initial stages
of production i.e. on Raw materials.

2.2 Methods of Tax Collection
Collection of tax is an important and tedious task for any state
government. It is not easy to collect the taxes in full amount from the whole
economy because a significant part of the economy consists of undocumented &
black economy which do not pay taxes. Therefore, considering the difficulties
of tax collection, several attempts has been made by the economists to devise
such a foolproof method that could help the government evade such barriers.
There are different types of tax collection methods such as a specific tax,
ad-valorem tax and combined tax that are used to collect taxes on consumption.
However, there are three different ways through which an economy can
determine the income tax rate for its individuals.


1) Proportional Taxation
As the name suggests, proportional taxation refers to a certain proportion
of the income that is to be paid as taxes. In proportional taxation, the
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government fixes a certain rate and every individual in the economy (who is
earning above a certain level) is bound to pay the taxes from his/her income,
according to the rate set up by the government.

2) Progressive Taxation
Many developed countries ascertain the income tax rate under the
progressive taxation system. In this type of taxation, the income tax rate
progresses as the income of the individual increase. Low income groups have
less burden of tax to bear, whereas high income groups have to pay more.

3) Regressive Taxation
Regressive taxation is widely being used among the developing countries
as a tool to determine their income tax rates. The regressive taxation works
inversely to the progressive taxation i.e. the income tax rate decreases as the
income of the individual increase. Therefore, high income individuals have the
benefit to enjoy reduced taxation as opposed to the low income group.

4) Lump-sum Taxation
It is a fixed amount of income tax imposed on the tax payer. No matter
whether the circumstances have changed favorably or adversely, the tax payer
has to pay a fixed amount as tax. It actually works pretty similar to the
regressive taxation.



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3
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FEDERAL BOARD OF REVENUE


3.1 Introduction
The Federal Board of Revenue (more commonly known by its initials as
FBR) is the semi-autonomous, supreme federal agency of Pakistan that is
responsible for auditing, enforcing and collecting revenue for the government of
Pakistan. It is the prime governing body of Income tax in Pakistan. FBR is
estimated to be the largest federal bureaucracy in Pakistan. As the agency
conducts audit of taxpayers regularly, it's regarded as the guardian of national
treasury in Pakistan. FBR primarily operates through its main collection arms,
its field formations, the Regional Tax Offices (RTOs) and Large Taxpayer Units
(LTUs) across the country. FBR has two major wings: the Inland Revenue
Wing (Income Tax Department) which brings in over 90% of FBR's total
collection and Customs Wing now called as Pakistan Customs Service.
Mostly in the media, the acronym 'FBR' is also often mentioned when
speaking in relation to Inland Revenue Officers (previously Income Tax
Department officials) in Pakistan. For the purpose of collection of revenue and
pursuing tax evaders, FBR's powers & functions also include but are not limited
to: carrying out inquiries and audits/investigations into the tax affairs,
commanding arrests, attachment as well as public auction of movable and
immovable assets of a non-compliant.
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3.2 History of FBR
The Central Board of Revenue was created on April 01, 1924 through the
Central Board of Revenue Act, 1924. In 1944, a full-fledged Revenue Division
was created under the Ministry of Finance. After independence, this
arrangement continued up to 31st August, 1960 when on the recommendations
of the Administrative Re-organization Committee, CBR was made an attached
department of the Ministry of Finance. In 1974, further changes were made to
streamline the organization and its functions. Consequently, the post of
Chairman CBR, was created with the status of ex-officio Additional Secretary
and Secretary Finance was relieved of his duties as ex-officio Chairman of the
Board.
In order to remove impediments in the exercise of administrative powers
of a Secretary to the Government and effective formulation and implementation
of fiscal policy measures, it was decided to restore the status of the CBR as a
Division under the Ministry of Finance. Thus, Revenue Division was re-created
on October 22, 1991. This experiment continued for a short period. In January,
1995, Revenue Division was abolished and CBR reverted back to the pre-1991
position. However, from December 01, 1998, Revenue Division was once again
re-created and it continues to exist as such.
On July 15 2006, the government has decided to convert the Central
Board of Revenue (CBR) into an independent entity as 'Federal Board of
Revenue' (FBR), enhancing its financial and operational autonomy for smooth
functioning, with additional powers to take decisions on taxation/reforms
related matters, and to authorize it to demand taxpayer's related information
from any department/bank/financial institution/housing society to maintain a
'national database'. The CBR has drafted 'Federal Board of Revenue (FBR) Act,
TAXATION IN THE ECONOMY OF PAKISTAN
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2006' which would repeal the 'Central Board of Revenue (CBR) Act, 1924'. The
FBR would have provisions to override any other government law.
The 'FBR Act' would set up an 'Advisory Board' comprising Minister of
Finance or Advisor to Prime Minister on Finance and Revenue; Chairman CBR
and three other members from the public/private sector. The 'Advisory Board'
would be a supervisory body to monitor the functioning of 'FBR' and
independently make annual budget allocations.
Following are the reasons of converting CBR into FBR.
1. The independent board would give legal sanctity to the ongoing reform
process.
2. It will enhance operational and administrative autonomy of the CBR.
3. The 'Board' will take decisions with minimum interference from the
Ministry of Finance.
4. It will meet human resource management (HRM) requirements needed
for the reformed units.
5. It will help in meeting the international obligations under bilateral
treaties/implement international regulatory frameworks.
6. The 'FBR' will meet the requirements of CBR's vision and mission to
make it a modern tax-friendly organization.
7. It will give protection to the taxation structure/tax administration under
the reform agenda.
8. It would collect taxpayer's information from any government department
for compiling a 'national database'
9. It will set up an 'employees welfare fund' with an initial capital of Rs 500
million.
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10. The 'Federal Board of Revenue Act, 2006' will have provisions to
override all other government laws.

3.3 Functions of FBR
According to the Act, following are the functions of FBR:
The 'Board' shall have all necessary powers as may be necessary to
perform its duties and functions under 'FBR Act 2006'. It will prepare,
with the advice of the Advisory Board, the revenue expenditure budget
for each financial year.

The 'FBR Board' shall be responsible for the regulation, administration,
assessment and collection of taxes, whether federal or provincial, if so
provided by law. It will be empowered to conduct research and frame a
code of conduct for employees to enforce accountability.

The 'Board' may in consultation with the Advisory Board, calculate taxes
and duties, adopt streams of taxes and duties and/or make it identifiable
as inland revenue and customs duties, or internal taxes and duties. It will
identify matters to make policy decisions and may also make
recommendations regarding policy to the federal government for its
consideration.

The 'Board' may adopt best international practices followed in other
countries for improving collecting of duties/taxes.

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3.4 Organizational Structure of FBR
The following diagram depicts the organizational structure of Federal
Board of Revenue. It is pertinent to mention here that the following chart for the
organizational structure is made according to the current Audit Manual,
published by FBR.




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4
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METHOD OF INCOME TAX COLLECTION
IN PAKISTAN
A tax must be imposed in accordance with the individuals ability to pay.
Therefore, income tax is considered as the most equitable tax which is imposed
on an individual according to his/her income.
In Pakistan, as we have discussed earlier, Federal Board of Revenue is
responsible for the collection of Income Tax. According to the Income Tax
Rules 2002, the taxation in Pakistan is progressive in nature i.e. higher income
individuals have to pay higher taxes.
Tax rates and method of calculating taxable income varies with fiscal
status of the tax payer. Following are the broad categories of taxpayers:
Companies
Association of Persons (AOP)
Non Salaried Individuals
Salaried individuals
The FBR collects the income tax from the above mentioned categories of
tax payers. The companies are bound to submit their financial statements at the
end of every fiscal year to the Audit Department of FBR, which then assesses
the amount of tax to be paid by the companies. Tax collection from Association
of Persons & Non-salaried individuals is somewhat similar in nature and is
subtly different from the companies. Lastly, the salaried persons have to pay
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taxes on their monthly salaries and the salaried persons take home income is
their disposable income i.e. Income after the deductions of taxes.
Category-wise detailed valuation of tax rate and its calculations can be
found in the I ncome Tax Rules 2002, I ncome Tax Manual (Amended
up to September, 2008)


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5
ADVANTAGES & DISADVANTAGES OF
TAX COLLECTION METHOD IN
PAKISTAN

As discussed earlier, Pakistan follows progressive taxation for the matter
of income tax collection. At a glimpse, progressive taxation looks fabulous to
the many people, however, there are certain disadvantages of progressive
taxation of its own as well as it has some other disadvantages that are created
due to the economic turmoil in Pakistan. Let us discuss some of the advantages
of progressive taxation first:
Progressive taxation helps in reducing income inequalities. Income
inequality refers to the situation of wealth concentration in the hands of a
small group of people. Since Pakistan has vast income inequalities,
therefore, progressive taxation seems to be the best way for the
redistribution of wealth and the alleviation of income inequalities.
According to the theory of Ability to Pay, progressive taxation seems
fair, because the burden of tax is more on high income individuals. The
poor people enjoy the benefit of having low income and thus enjoy lower
tax rates.
It enables the government to generate hefty revenues by taxing higher to
the high income group.
Progressive taxation means more revenue for the government, which
ultimately helps the govt. to spend heavily on public goods.

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These are some of the advantages of progressive taxation; however, there are
many disadvantages as well that serve as hindrances in the economic expansion
of Pakistan. Some of these disadvantages are highlighted below:

Progressive tax though reduces the income inequalities, but on the other
hand it punishes the hard workers in the economy. Thus, people are
discouraged to work more and earn more just to avoid the high rate of
taxes. Keeping in view the current economic situation of Pakistan,
Pakistan requires heavy FDI inflows. However, due to progressive
taxation, investors are discouraged to invest in Pakistan.
The incidence of progressive taxation is different on every income group.
Therefore, it is considered to be unfair, as some people are paying more
to government while the others are paying less. Progressive taxation thus
defies the theory of Tax according to Benefits.
Due to progressive taxation, many Pakistanis are shifting their assets to
overseas, which in turn is affecting the economy of Pakistan to a great
deal.
The GDP value goes down by a significant percentage because people are
unwilling to take high paying jobs and thus many workers are
underemployed in the economy.
Progressive taxation encourages the business owners to show low profits
to avoid high taxes, which does not only result in lower tax revenues but
also raises the level of corruption.


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6
CONCLUSION & RECOMMENDATIONS

6.1 Conclusion
Pakistan is a developing country, facing severe difficulties on the path of
economic growth. The crippling economy of Pakistan has always been a
challenge to its economists to deal with. Our topic of discussion was centered
on income tax. The method of income tax collection is Pakistan is progressive
in nature, which despite of having many advantages have some serious demerits
that requires the attention of Pakistani economists on urgent basis.
Apart from anarchic situation and political turmoil, the main reason of the
declining trend of FDI inflows in Pakistan is the progressive taxation and lack
of feasible business opportunities. Foreign investors are highly discouraged
because of lower profits and high taxation. Moreover, the documentation and
other formalities also add up to a significant amount which increases the sunk
cost by a hell lot of amount.
In addition to this, the tax collection rate of Pakistan is only 0.57% which
is almost negligible. According to the recent sources, only 800 thousand people
are paying their taxes out of the population of 190 Million. This is a serious lack
on the part of tax collecting authorities.
A quick glance at the trends can help make obvious remarks that the
progressive taxation is unsuitable for Pakistan and the governing body should
seriously look for the solutions that could help stabilize the negative effects of
improper taxation and could increase the number of tax payers.

TAXATION IN THE ECONOMY OF PAKISTAN
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6.2 Recommendations
After analyzing the facts and figures carefully, following are some
recommendation that we would like to elicit to be considered for the sake of
betterment of Pakistan:
The Federal Board of Revenue with the help of some leading economists
should devise some other method of the determination of tax rate, which
is efficient as well as equitable.
The board should consider adopting regressive taxation, so that it could
help in the generation of FDI inflows. Moreover, the tax payers would
then be willing to pay their taxes happily.
Regressive taxation would help encourage hard work, and the incentive
of lower tax rate to the business class would be highly encouraging and
would affect the GDP positively.
The Federal Board of Revenue should take immediate steps for the
recovery of the unpaid taxes. It should devise such a strategy that could
ensure 100% tax paying participation rate.
The example of France and South Africa should be considered as a model
of reformation in taxation. Following the footsteps of these economies
would certainly pave our path towards success and high economic
growth.


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7
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APPENDICES

7.1 References
Albanesi, Stefania and Christopher Sleet, (2006). "Dynamic Optimal Taxation
with Private Information," Review of Economic Studies 73, pp. 1-30
Chase, G., & Upton, C. W. (2000). Lecture 8: Inflation. Retrieved from
http://www.personal.kent.edu/~cupton/bbamacro/ma08.htm
Dahan, Momi, and Michel Strawczynski. 2000. Optimal income taxation: An
example with a U-shaped pattern of optimal marginal tax rates:
Comment, American Economic Review, June, 90 (3), 681-686
Lucas, RE Jr., & NL Stokey. (1983) Optimal Fiscal and Monetary Policy in an
Economy without Capital. Journal of Monetary Economics 12, pp 5593.
Matobela, C., (2012). A comparative Study on the benefits and disadvantages
of implementing a wealth tax in South Africa, University of Pretoria, pp
2-5
7.2 Secondary Sources
1) http://www.indexmundi.com/g/g.aspx?c=bg&v=71
2) www.fbr.gov.pk
3) start.sd34.bc.ca/mshayhoe/wp-content/uploads/.../History-of-Taxes.doc
4) http://onlinebooks.library.upenn.edu/
5)http://www.runningromans.com/Academics/Economics/Econ%20Review%20
Notes/Formulas%20and%20Definitions.htm
6) http://quizlet.com/12172179/macroeconomics-formula-sheet-flash-cards/