Withholding-ization: Where is the reform?

Mar 16, 2023
Tags :
  • currency in circulation,
  • Federal Board of Revenue (FBR),
  • tax,
  • According to the Federal Bureau of Revenue (FBR) database, only about a fourth of the tax collections in the country come through direct taxes. The majority—historically, 60-70% of taxes are indirect taxes—mainly sales tax and customs duties. That’s problematic, though not as problematic as this: more than 70% of direct taxes in Pakistan are withholding taxes collected through withholding agents. Over the years, more withholding tax measures have extended beyond income withheld to a variety of transactions. This has made tax-paying entities collect tax on behalf of FBR and incur the cost of collection.

    What began as a reform that could potentially move the needle on Pakistan’s stagnant tax collection as demonstrated by the tax-to-GDP ratio stuck between 9 and 10% (within which the revenues are already leaning heavily on indirect tax collections at 6.5% of GDP), the withholding tax regime in Pakistan has fallen short of delivering the envisaged outcomes and is symptomatic of a system in disarray; having macroeconomic implications. According to the IMF, the minimum level considered necessary to support long-term economic growth is a tax-to-GDP of 15%[1]; that has never been achieved in Pakistan.

    Figure 1: Withholding tax in direct taxes

    Tax base narrowness

    Tax collection—specifically direct tax collection has always been low, enabled by a narrow tax base that has remained mostly stagnant. Only a handful of sectors such as Oil & Gas, Banking, Telecom, Tobacco and Cement account for the lion’s share of direct taxes while FBR relies heavily on indirect taxation, particularly sales tax and import tariffs. Potentially massive income tax-generating sectors such as real estate, which mostly operate informally, have made insignificant contributions to tax revenues. Attempts to capture such sectors in the tax base have not been effective either.

    Comparing the sectoral contribution to GDP with the respective sector’s contribution to tax revenue gives a sense of just how narrow the tax base is. In FY20, for instance, whereas the manufacturing sector contributed 12% to the GDP, its contribution to tax revenue was the highest—at 37%. This is in contrast to agriculture or services where contribution to GDP is significant (See figure 2) but tax revenues are not.

    Figure 2: Sectoral tax contribution vs GDP contribution

    The withholding tax concept is, globally, a popular mechanism to collect income taxes. Taxes are withheld as income is paid, rather than paid at the end of the year. The taxpayer is paid refunds if the tax collected is higher than the liability. However, in Pakistan, this concept has been extended beyond specified chunks of income to a large variety of transactions with the main motivation for the tax authority to meet revenue targets. Officially though, the primary purpose of the expansion in the withholding tax regime as claimed by FBR was to collect data on potential taxpayers and “net them into the tax system”. This hasn’t happened because the tax base remains unchanged.

    Why are withholding taxes a problem?

    Withholding taxes essentially transfers the responsibility of tax payment onto the withholding agent. The compliance of a withholding agent has a cost, which to an SME is significant. A study by Karandaaz Pakistan on the state of business taxation for SMEs found that many manufacturing SMEs consider this a costly inconvenience. One SME argued: “Why is the industry expected to be the office of FBR? Not only do we have to meet our tax obligations, but we are also paying to become tax collection agencies!”

    The withholding agent not only has to meet compliance requirements, and reporting requirements[2], and be subject to audits but also faces punitive measures[3] in case of failure to perform their withholding duties. In the case of non-adherence, the agent must pay the amount they were supposed to deduct out-of-pocket, while in case of adherence too, they incur administrative costs. In reporting, each month the withholding agent has to furnish withholding statements for the tax authority that requires them to provide information on all withholding tax collected aside from reproducing their entire cash book and bank book. The statements have to be submitted online, which requires the in-house capacity to meet reporting requirements, adding to compliance costs. In an instance cited by a PIDE study, in 2017, for the months of May and June alone, a total of Rs2 billion penalty was imposed on non-filing of withholding statements in Rawalpindi jurisdiction. This penalty far outweighed the total tax imposed under the normal law by the entire Regional Tax Office, Rawalpindi[4].

    Between 1995 and 2017, the number of withholding agents has gone up exponentially—from less than 20 to over 125,000 during the period. Over the years, the increase in withholding tax provisions has made this measure the top source of revenue collection for the FBR.[5] Broadly, 182 different transactions and 42 incomes are captured by the withholding tax regime. Not only has the state almost extricated itself from the process, but also from the effort of reaching out to the correct tax base or expanding the existing tax base; as a result, strangling its tax administration.[6] The rates meanwhile have varied year after year—often increased—to meet tax revenue gaps. Whereas the third-party information collected by the FBR should be an enormous treasure trove of valuable data, it is clear that the FBR has not been using the data collected through withholding agents to identify fresh tax pockets. Its efforts to collect taxes have fallen—from 7% to 5%–over the past five years with an ever-growing reliance on withholding taxes.

    Figure 3: Direct tax collection by type

    The burden of withholding

    The withholding regime has also shifted resource allocation within the tax collection machinery from normal to withholding taxes. Over the years, the tax authority has grappled with its limited capacity to identify unregistered firms and individuals with incomes liable for tax and this has only worsened with the withholding tax regime. The transference of resources from normal tax to withholding tax regime for instance, in the form of performing monitoring and audits, chasing after non-filing with holders and penalizing them lays in sharp contrast with FBR’s limited efforts in collecting information on “massive money laundering ploys, illegal remittances, beneficial transactions and cases of mega tax evasion[7]”.

    As a result of this tunnel-vision focus on a revenue-yielding withholding regime, the normal tax regime has been pushed into the backburner. Meanwhile, elitist enterprises have wriggled out of the regime through politically-motivated exemptions and SROs, leaving the burden on the rest, including SMEs and small entrepreneurs. From an investment point of view, the compliance and reporting requirements add to the cost of doing business and penalties discourage new entrepreneurs and businesses.

    Pakistan’s tax collection cost is 0.73% compared to the world average of 2.5%. However, if the cost of withholding-borne by private entrepreneurs is taken into account, Pakistan’s national cost of tax collection would be between 3.5-4%, probably the highest in the world. The excess is therefore spent by the Pakistani society (including businesses) out-of-pocket and should be dubbed as a deadweight loss to the country.

    At the same time, there is also the matter of withholding taxes affecting end-users/consumers and as another consequence, inflation. As argued by Ashfaq Ahmed: “It is stipulated that withholding-ization being applicable at each meeting point in the transaction chain cumulatively enhances the end-price of goods and services being produced in the economy—triggering a process that could operationally be dubbed as taxflation”. Much of this is neither refunded nor adjusted.

    This system is regressive in more ways than one. Individuals that fall below the income tax threshold have income tax withheld on their transactions such as utility bill payments, vehicle tokens etc., whereas those below the taxable limit are burdened unduly. However, for high-income businesses and individuals that are non-compliant, it is preferable to pay these withholding taxes on transactions than to pay income tax and file returns with the FBR. As a result, instead of capturing new taxpayers or expanding the existing tax base, this regime provided a new avenue for high-income non-tax compliant businesses and individuals to remain uncompliant.

    Figure 4: WHT vs Currency in Circulation

    There have been other consequences of different withholding tax provisions. For instance, in FY15, the government introduced a withholding tax on bank transactions, which led to an increase in currency in circulation and a decline in private business deposits while having a negligible impact on revenue collections”.[8]   Figure 4 shows currency in circulation grew nearly 22% on average between July 2015 and June 2017 against an average growth of 14% recorded in the 11 years prior.

    This withholding tax along with those on economy air travel, stock exchange, CNG stations, petroleum products, international debit and credit card transactions, and extraction of minerals were removed in Finance Act 2022. This is being done as part of the Disbursement Linked Indicators (DLIs) of a World Bank Project in Pakistan. By 2024, the number of withholding lines is expected to drop to 20, down from 58. But this is unlikely to loosen the noose on those most affected by the regime because state incapacity and overdependence on withholding taxes cannot be overturned without substantial reforms.

    Today, FBR’s efforts in tax collection yield only about 4 to 5% of direct tax collections—a share which has fallen over the years (Figure 3). In essence, FBR has not only failed to increase revenue collection to meet economic growth targets—which by the way continues to push the economy into debt—but has also failed to use the withholding tax regime to do what it was supposed to—increase the existing tax base.

    [1] IMF. 2016. Working Paper: Tax Capacity and Growth: Is there a Tipping Point? Vitor Gaspar, Laura Jaramillo, and Philippe Wingender. Washington, DC: IMF. https://www.imf.org/external/pubs/ft/wp/2016/wp16234.pdf
    [2] Withholding agent has to submit monthly withholding statements. Non-furnishing of monthly withholding statements calls for imposition of penalty at the rate of Rs. 2,500 per day (subject to a minimum penalty of Rs.10,000)
    [3] Withholding agent is personally liable for the tax that was not withheld out of pocket. In addition, the defaulting withholder would pay “default surcharge at the rate of 12% per annum from the date he failed to collect or deduct the tax to the date the tax was paid. The failing of “withholding duties” may also subject the defaulter to additional fines and even imprisonment.
    [4] Ashfaq Ahmed. “Pakistan: Withholdingisation of the Economic System—A Source of Revenue, Civil Strife, or Dutch Disease+?”. PIDE. Web. https://pide.org.pk/pdfpdr/2020/469-516.pdf
    [5] ibid
    [6] ibid
    [7] ibid
    [8] Special Section-1, Annual Report 2017, State Bank of Pakistan. Web. https://www.sbp.org.pk/reports/annual/arFY17/Special-Section-1.pdf

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