Why can’t Pakistan adopt practices from developed countries to reform its tax system?

Published: October 10, 2019
Email

The national flag is seen on the Federal Board of Revenue (FBR) office building in Karachi. PHOTO: REUTERS

Why is it so difficult to evade taxes in developed countries? Couldn’t we just adopt the same systems and improve our tax collections? If they have figured it out, why can’t we just copy them? What’s all the fuss about? These questions regularly come up in conversations when someone finds out that I work in public finance. Since taxation has become a hot topic over the last year, Pakistanis are curious to know more about whether or not we can simply transpose tax policies from other nations into Pakistan. But the realities are a little more complicated than that. Let me try explaining the basics in order to help address this.

Let’s start with developed countries. Anyone who has lived in such countries would know that evading taxes is possible, but extremely difficult. There is no single factor that explains this phenomenon. However, two factors play a significant role. First, most of the economy is in the formal sector and, as a result, documented. This also means that most transactions are routed through banks and not just based on cash. This leaves a paper trail for most transactions, making it easy for the tax authorities to audit people. Take the example of a retailer that made a profit of $1,000 in a particular year. If the same retailer files their tax return declaring a profit of $500, the auditors can tally the bank statement with the declaration to figure out the discrepancy. The retailer can be caught for tax evasion and since they know this, the likelihood of evasion is much lower. However, for the sake of simplicity, in this example, I am not taking into account differences in the definition of profit in the tax law and accounting standards.

Second, being caught for tax evasion leads to serious penalties, including jail-time. This means that the state has not only passed legislation with these penalties but is also effective in implementing them. Carrying forward the example of the retailer, this means that the cost of evasion is very high. From the previous point, the probability of being caught was high due to the existence of a paper trail. From this point, if the retailer gets caught, the cost will also be very high.

Now moving on to the next question, if developed countries have solved the tax problem, why can’t we do the same, or just copy them? This is where things get complicated. The most common mistake that people make about economic development is that they often make a flat-out comparison between developed and developing countries. The context of every country is so different that no comparison is justified. A simple example will help illustrate this. Now assume that the retailer is based in Pakistan instead and conducts all of their transactions in cash. There is no third-party paper trail of the same transactions making it extremely difficult to audit. This lowers the probability of being caught for evasion. The larger problem here is that a major part of the Pakistani economy is informal, and cash based. An added complication is that economies naturally become more formal as they become more developed. Should we take this for granted and sit back, or actively start a documentation drive? These are questions that tax authorities in developing countries often have to deal with.

In addition to this, being caught for tax evasion usually does not lead to serious penalties, or jail-time. Explaining why this is the case would take very long. Hence, I’ll restrict myself to the major factors that explain this fact in Pakistan. First, taxing people leads to a political backlash that governments often can’t withstand. Everyone wants the government to have enough tax money, yet most aren’t willing to comply voluntarily with the law to help do that. This is why the laws around prosecuting people who do not file their tax returns are lenient. From an ethical standpoint as well, it hardly seems fair to send a few people to jail so that others comply in an environment where evasion is widespread. Anyone who is caught for tax evasion would automatically reply with a ‘Why me?’ Second, the government does not have the state capacity to effectively enforce taxes. State capacity and the role of the civil service is a separate and extensive topic on its own, which I won’t cover here. But these examples should give you a fair sense of why things are the way they are.

The reason we can’t just adopt the same systems and improve our tax collections is because the context of developing countries is very different. Their unique challenges mean that solutions can’t be imported from any other country. In fact, reform efforts that have copied best practices have often failed across the world. Therefore, tax enforcement in developing countries is complicated. Definitely doable, but at the same time very complicated – which is why simply copy-pasting taxation policies which have worked in developed countries is not the solution.

Muhammad Khudadad Chattha

Muhammad Khudadad Chattha

The author is a PhD candidate at the University of Oxford and is a graduate of the Harvard Kennedy School of Government. He has also worked as a civil servant in Pakistan and tweets @KhudadadChattha (twitter.com/khudadadchattha)

The views expressed by the writer and the reader comments do not necessarily reflect the views and policies of The Express Tribune.