Cost of tax compliance: Undoing SME growth
Since its independence, there has been no shortage of foreign assistance in Pakistan, frequently and irrevocably tied to foreign advice and “conditions”. Reforms to mobilize and shore up its coffers in a sustainable manner have failed to achieve the desired outcomes leading to Debt to GDP trailing greater than 50 per cent over the last two decades and exceeding 70 per cent many times during recent years. Pakistan has a crippling and long-running debt problem.
Policy reforms surrounding fiscal measures to improve tax to GDP have been part and parcel of most IMF programs expanding over the course of four decades. But often conditions have only added to tax complexities in the system with quick-fix and arbitrary tax impositions (through mini-budgets, special budgets or statutory regulatory orders) that did more damage than good. Over time, long-term reform needs were replaced with short-term measures to temporarily shore up revenues. For a large number of businesses today, especially SMEs, complying with the ever-changing tax policies and meeting tax regulatory burdens are some of the biggest challenges in doing business.
Tax compliance and the costs associated with it is certainly a size-related problem as it is fairly easier for larger firms to hire the necessary workforce and in-house consultants and advisors to ensure compliance and deal with tax authorities during audits. Increasingly, SMEs cite the burden of tax compliance as a bigger hurdle than the actual tax paid or the tax rates associated with it. Too many regulations meanwhile, add another layer to the cost. Without the adequate resources and skillset for timely compliance with tax obligations, SMEs end up having to pay penalties. In many developing economies, compliance costs are a major deterrent to tax filing.
In Pakistan, this may very well be true. For federal taxes, businesses have to file sales tax returns every month on IRIS and withholding tax (WHT) returns every quarter. This comes to 18 return filings in a single year with different frequencies for different types of taxes. Undoubtedly, there is a documentary burden here in terms of the time spent as well as the dedicated human resource requirement to meet compliance. For service providers, it is even more burdensome. Service firms have to file sales tax on services with each jurisdiction they are operating in including the FBR (five if they are operating in all four provinces) each month based on five different sets of rules for sales tax alone. This is because sales tax on services comes under the provincial domain. Annually, this comes up to 61 excessive tax returns. If automation was introduced to improve efficiencies, it has inadvertently increased the burden of compliance on firms where costs are likely disproportionately higher for smaller enterprises.
Following the devolution of GST on services, new issues have mushroomed such as multiple or overlapping taxations where disagreements in the definition of the product—whether it is a good or a service—causes firms to pay tax twice, once to the federal government as GST on good, and the second time to the provincial government as GST on service. One example is restaurants where Provinces have vehemently negated the Center’s right to collect GST on goods as restaurants are service providers. The Center argued that restaurants were providing food which should constitute “goods” sold. Other examples of disputes include transportation, toll manufacturing, construction etc. For now, these lingering conflicts are being resolved case by case. Sales tax harmonization is a major reform agenda under a World Bank loan which is under consideration but forthcoming solutions such as single-point of the collection have been met with resistance. Another reform suggested was the one-window operation where all taxes would be paid and filed on a single portal. Thus far, this has hit snags as there is a trust deficit between the federal and provincial governments and as such, provinces are not ready to relinquish control over their domain (i.e., collection of sales tax on services).
Lack of uniformity is another major challenge. Certain sectors enjoy relaxation while others do not. There is also an inherent lack of trust. For instance, the FBR has introduced a relaxed tax regime for manufacturing SMEs recently. For one, other sectors such as services or wholesale trade and retail don’t enjoy these benefits. For another, the regime does not extend to sales taxes and is limited to income tax. An SME would undoubtedly have to think long and hard before opting for tax compliance, knowing that once they are in the system, they could be chased by the tax collector for other forms of tax too. The result is that despite a relaxed regime, many SMEs remain hesitant about getting into the tax net.
Cumulatively, tax complexity hurdles and compliance requirements translate into monetary costs for businesses. In a study conducted by Karandaaz Pakistan on SME taxation challenges in the country, it was estimated that a firm hiring both a tax accountant and a financial account (for book-keeping) will incur anywhere between Rs0.7 million to Rs1.5 million every year which translates roughly to a dollar value of Rs 4,000-8400 annually. These calculations do not include time spent on complying with refund obligations, obtaining refunds or preparation of documentation for FBR audits. In addition, it does not include any software, IT-related or supplies-related costs. According to the calculations in the study, given assumptions stated by the authors, the cost of compliance to SMEs is anywhere between 1% to 4% of an average Pakistani SME’s revenue and 6-14% of an SME’s earnings. That is a substantial burden.
The cost of tax compliance is in addition to the actual taxes paid in the country, which are high and comparable to developed nations. On average, Pakistani businesses make 47 tax payments in the country, which is enormous, particularly compared to the regional and global average. Meanwhile, any costs incurred to comply with the arbitrary and frequent tax changes are not included here either. Also, remember that taxes distort prices which for SMEs already operating on thin margins results in growth suppression. When tax changes are arbitrary and too frequent, the lack of certainty in pricing further exacerbates growth prospects. As such, the existing tax regime in Pakistan is not conducive to growth and requires substantive reforms to simplify and declutter the system whilst reducing the compliance burden through effective automated solutions that reduce documentary obligations and touchpoints instead of mounting them.
Tax compliance relates to: the number of payments required to be made, the time spent to pay those taxes, the resources required to understand the tax codes and be fully tax compliant, the time and resources needed to file returns, meet documentary requirements and in case of audits, reproduce the books and relevant information for clarification to the tax auditors.
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