Corporate vs turnover taxes

Published May 12, 2016
The writer is a member of staff.
The writer is a member of staff.

NOW here’s something different. A recent post on an interesting blog called microeconomicinsights.org summarises the findings of a study published in 2015 with the rather dry title of Production versus Revenue Efficiency with Limited Tax Capacity: Theory and Evidence from Pakistan. Hardly an attention-grabbing title, but as with so much else in Pakistan, once you bring in any empirical material, the findings are almost always interesting. So it is with this study, whose authors are drawn from academia (the lead author is Michael Best of Stanford) and the World Bank.

“Where informal sectors and the cash economy are dominant, taxable economic activities are easily hidden and don’t leave behind verifiable information trails, such as receipts, bank records and credit card information. Audits are few in number and poorly targeted — partly because of the weakness of information trails — and tax evaders are rarely caught, let alone punished” they argue, going on to ask “[w]hat should tax policy look like in an environment of weak enforcement? In particular, how should businesses be taxed?”

Their answer is greater reliance on taxing turnover rather than profits, because turnover taxes are harder to evade. Sounds simple enough at the moment, but the empirical results upon which this conclusion is built are quite interesting.

They start by looking at the minimum tax scheme in Pakistan, where a firm’s presented with a choice: pay taxes on your profit or on your turnover. Of course, the choice is not exactly intentional, there is a trigger, or floor, to decide which of these will be applicable. If the firm’s total tax liability is less than 1pc of turnover, then it will pay 0.5pc of its turnover as tax, otherwise it’s tax of profits.


In an environment of weak enforcement and high levels of informality, firms can inflate their costs or conceal some of their revenues.


This devolves into a choice for the firm and its management because in an environment of weak enforcement and high levels of informality, firms can inflate their costs or conceal some of their revenues to decrease their profits, and thereby bring themselves down into the lower tax base.

But at what point will this shift from profits to turnover kick in? What is the magic number where the firms are most likely to make the switch? Many firms are not likely to be able to misreport their data to the point where they can make themselves fall into a different tax base altogether. Who is best able to take advantage of the “kink point” as the authors call it, which is the point where the turnover tax and the profit tax meet?

That magic number is 1.4pc, according to the authors. Those firms whose profit rate is 1.4pc, calculated as profits divided by turnover, can best move from one category to the other. How did they get this figure? Simple, it’s the ratio of the two taxes in question: turnover to corporate tax, that is 0.5 as a percentage of 35.

“We argue that if it is easier to evade profit taxes than turnover taxes, then firms will have a strong incentive to locate at or around the kink. For example, consider a firm with a true profit rate of 3pc. To evade taxes, the firm can overreport its costs so that its reported profit rate falls to about 1.4pc. At this point, the firm will be required to pay taxes on turnover and any further exaggeration of its costs has no impact on its tax liability.

“The firm could further reduce its tax liability by also underreporting turnover, but hiding output may be more difficult than fabricating costs. In this case, the firm will settle for a reported profit rate of about 1.4pc.”

So 1.4pc is the magic number, and if you are inflating your costs and reducing your declared profits in order to push yourself down into the turnover tax bracket, you will do so only just enough so as to get yourself inside the bracket and no further. Which means if we look at the profit rates of Pakistan’s firms, as declared to the tax authorities, and we understand that there is large-scale evasion going on through inflating of costs and underreporting of profits, then there should be a large number of corporates bunched around the 1.4pc profit rate.

For the years 2006 till 2009, when the turnover tax was 0.5pc, the largest number of firms was bunched around a profit rate of exactly 1.4pc. In 2010, when the turnover tax was changed to 1pc, the “kink point” moved to 2.8pc as well. And guess what? The number of firms reporting a profit just below 2.6pc became the highest in the entire sample, meaning as the kink point moved, so did the reported profit rate.

“The sharp bunching around the kink must be driven by evasion rather than real output changes,” argue the authors. If a large number of corporates are declaring their profits to situate themselves right at the inflection point where taxes on profits end and tax on turnover begins (which is much lower), then it shows that having this discontinuity in the tax scheme creates an incentive to which corporates respond powerfully.

The answer is simple: “the turnover tax in Pakistan reduces evasion by as much as 60-70pc of corporate income compared with the profit tax.” Applying their model further, they estimate that “switching from a pure profit tax to a pure turnover tax can increase revenue by up to 74pc without reducing aggregate profits”.

This is a thought worth considering in the run-up to the budget. There is a downside of course. Turnover taxes create an incentive to reduce overall output, and there is a chance they can serve as a drag on the growth of firms, but the strong preference shown by a large chunk of Pakistani corporates to opt for turnover taxes, and the ease with which profits can be misstated, are both reasons to give the suggestions of this study some serious consideration.

The writer is a member of staff.

khurram.husain@gmail.com

Twitter: @khurramhusain

Published in Dawn, May 12th, 2016

Opinion

Editorial

Judiciary’s SOS
Updated 28 Mar, 2024

Judiciary’s SOS

The ball is now in CJP Isa’s court, and he will feel pressure to take action.
Data protection
28 Mar, 2024

Data protection

WHAT do we want? Data protection laws. When do we want them? Immediately. Without delay, if we are to prevent ...
Selling humans
28 Mar, 2024

Selling humans

HUMAN traders feed off economic distress; they peddle promises of a better life to the impoverished who, mired in...
New terror wave
Updated 27 Mar, 2024

New terror wave

The time has come for decisive government action against militancy.
Development costs
27 Mar, 2024

Development costs

A HEFTY escalation of 30pc in the cost of ongoing federal development schemes is one of the many decisions where the...
Aitchison controversy
Updated 27 Mar, 2024

Aitchison controversy

It is hoped that higher authorities realise that politics and nepotism have no place in schools.