Taxation with equity

AI Summary

The departure of numerous multinational companies from Pakistan has highlighted significant issues within the local business environment, including ineffective taxation policies and administrative inefficiencies. This has led to growing concerns over rising informality and hindered domestic businesses, indicating a need for comprehensive reform.

THE exodus of a large number of multinational companies (MNCs) over the past two years should have raised red flags among policymakers and the IMF. Instead, it has been met with a business-as-usual approach. Despite the glib explanation of how ‘global capital allocation decisions’ were the main factor behind the high-profile exits, three associated facts point clearly to deeper issues closer to home. The first is the sheer number of companies choosing to exit, in conjunction with the wide range of sectors the MNCs were involved in, ranging from telecoms to mobility to oil and gas, among others. The second fact is that many of the MNCs exiting the country had been operating profitably for decades. They had weathered many crises in Pakistan, including conflicts and disturbed internal security conditions for prolonged periods. Clearly, an inflection point of sorts was reached over the past four years compelling them to pull the plug. Finally, while attention has focused on MNC exits, domestic businesses face the same difficult operating environment and their closures are getting less visibility. Pakistan is experiencing a silent economic scarring or ‘hysteresis’ under IMF programme design and government apathy. Most commentary on the business environment mentions policy inconsistency as the main culprit behind this state of affairs. While this is largely true, in at least one critical area, however, the unfortunate fact is that all governments past and present have been consistent — in continuing with bad tax policy, poor tax administration and weak enforcement. Predatory taxation of the formal sector is a fundamental factor in rising informality. Formal businesses face real and significant costs navigating a complex tax regime, with multiple tax and reporting jurisdictions, a heavy-touch regulatory regime, and high cost of compliance and weak enforcement across sectors. In addition, the failure to expand the tax base has meant an increasing reliance on making formal businesses withholding agents. Unable to force unregistered suppliers to register, the additional cost is absorbed by formal businesses. In the case of the fast-moving consumer goods (FMCG) sector, for example, the additional cost borne by the formal, registered companies on this account alone is 6.5 per cent. This is not an insignificant compression of margins in an overall high-cost environment. The taxation regime is a potent shaper of the incentives framework for firms operating in a country. It influences firm-level decisions on whether to operate in a jurisdiction, which sector(s) of the economy to invest in, to operate as a large, visible consolidated player with economies of scale or to operate ‘under the radar’ of authorities as a fragmented and undocumented business. This applies not just to tax policy but equally importantly to its uneven implementation across sectors and income groups. This situation, reinforced by IMF programme design, has created a negative feedback loop where a narrow tax base is shrinking ever more with potential adverse revenue consequences in the longer term. The nexus between a failed tax system and rising informality has been a subject I have highlighted for several years, with this point also being made recently by Nadeem ul Haque and Shahid Kardar in this newspaper. What can policymakers do to improve the operating environment for formal businesses without compromising tax collection? There are some specific low-hanging fruits that should be considered in the upcoming budget. The two main objectives should be to improve the business and investment environment for the remaining multinationals as well as for large, documented, formal local firms whose growth potential is being severely restricted by the country’s over-burdening tax regime. The government can introduce doable improvements in tax policy, and enforcement by FBR, which have the potential to generate hundreds of billions in additional tax revenue. The first measure is improved enforcement, especially in illicit trade-prone sectors with major tax revenue potential. The Pakistan Business Council estimates the value of annual illicit trade in the country at a staggering $68bn, which directly undercuts government revenue as well as survival of compliant formal firms. To compensate for the tax revenue loss from a flourishing illicit trade, FBR resorts to overtaxing tax-compliant firms. This pattern is repeated across industries, be it tea, tyres, footwear, cigarettes, fast-moving consumer goods, beverages etc. The scale of the potential tax revenue gain through improved enforcement is illustrated by the tobacco industry. With over 40 cigarette manufacturers operating in the country, only two (the multinational firms) are fully tax- and public health regulations-compliant. Reliance on frequent and ad hoc changes to the excise taxation regime, coupled with weak tax enforcement, have shrunk the sales of legitimate cigarettes. With the major share of ci