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Pakistan incorporated

July 02, 2013

THE 2013-2014 budget should not be the yardstick to measure the new government’s performance or strategic direction on account of the short time period they had to finalise the budget proposals.

However, the expected creativity was lacking, and the burden of state deficits seen to be shifted to existing taxpayers, which is not a long-term solution.

For years we’ve heard the rhetoric of “broadening the tax base” which seems to have been falling on deaf ears. This could be either because the concept’s implementation methodology is not fully understood, or it is felt that tough measures required to bring taxable economic activity into the net would be difficult in a country driven by social and political pressures.

But the answer is simple: document the economy — in a way which benefits economic activity.

The classic example is that of corporatisation of businesses. Sixteenth-century Europe cashed in on this centuries ago. Register businesses by introducing a fair system of taxation which motivates businesses to file tax returns, and in the process document the economy.

If incorporated, individuals can also take advantage of limited liability, hence shared risks and easier access to finance.

Yet, despite the corporatised form of business dominating the developed world for the last few centuries, we’ve only managed to corporatise 2pc of our businesses.

Around 63,000 businesses out of an estimated three million operate in the form of a company structure.

An economic model driven by corporatisation of all businesses, irrespective of their size, sector or form, with every business contributing a share of its profits to the exchequer will help the state reduce taxes across the board and grant relief to the public.

Changes in duties and tax rates alone will not help us take the tax-to-GDP ratio to a level of 15pc or higher. Something more needs to be done.

Once we realise that ‘something’ needs to be done, the next question is: ‘what?’ The first, most obvious answer is political will. After recognition of this need, achieving an incorporated Pakistan over the next five years is a doable task.

The second is already being worked on — the Corporate Laws Review Commission established in 2006. During my tenure as chairman, Securities and Exchange Commission of Pakistan, we set up a dedicated secretariat to give impetus to this project, and to complete the research on and drafting of a new company law.

Till date, we have been making ad hoc amendments to the existing company law. The proposed law is to be developed on specified principles, including the simplification of processes of registration, development of audit standards, giving investors a wider array of corporate structures, and moving towards a regime of proportionate regulation and enforcement without hassling the investors.

The third, and related requirement is that of taxation. Presently, incorporated entities pay taxes at a rate of 35pc, and are subjected to greater audit and regulatory requirements; whilst partnerships and individuals pay tax at a rate of 25pc, with little or no reporting or regulatory requirements.

How then are we incentivising documentation? There is historical justification for this anomaly — the decision to encourage small businesses may have been right at the time that it was taken, but the business world has changed since then and the same objective can be achieved today by regulating entities in proportion to their size, as opposed to discouraging incorporation by levying higher taxes.

Fourth is a conducive regulatory environment. If our businessmen perceive other jurisdictions to be more business-friendly with lesser possibility of unfair treatment, then we are doing something wrong. There has to be a revamp of the regulatory structure in Pakistan, especially in terms of development of HR.

Austerity measures should never compromise the quality of HR and foreign regulators need to be invited to Pakistan to impart skills, knowledge and training. This, coupled with market-based compensation packages and a performance-based work environment, will minimise the potential for misuse of power by the regulators. It would also expose the regulators to their role in developing the economy of Pakistan, as opposed to merely policing it.

Last, an acceptable rate of taxation needs to be ensured. The basic principle driving higher collection of taxes should be that if the government needs more money, it should encourage people to make and declare more money rather than avoid investing, and try and hide profitability to evade taxes.

The classic example is that of Far Eastern and Middle Eastern countries, which have kept the tax rate low but enforced it strictly, and their businesses are willing to pay the taxes as they are perceived to be fair. If we were to reduce our tax rate further and ensure that all businesses in Pakistan, irrespective of their form and size, are registered and subject to taxes, will we be better off or worse off?

We also need to rethink whether tax rate should be a function of the form of business or its profitability. The latter would be a more plausible answer — a business earning a lower level of absolute profit should be subject to a lower tax rate irrespective of its form, especially when its accounts and operations are more transparent, subject to greater regulatory scrutiny and it is therefore less likely to evade taxes.

The federal government should consider taxing corporations at a rate which is lower than other forms of business. To avoid the possibility of tax loss in the short term, the transition can be phased out over the next few years.

These recommendations are neither difficult to execute, nor will they require a lot of courage. But they do require political will — and from the gradual reduction of the corporate tax rate in this year’s budget, it seems that the will does hopefully exist.

The writer is the former chairman, Securities and Exchange Commission of Pakistan.